Throwback Thursday – What Is Float? On Float Part 2

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This is another post in our ongoing Throwback Thursday’s Series, where we share with you posts from the past blogs to bring you a ton of value and help you learn.

In Part 1 of this Throwback series on float, we talked about Charlie Munger’s thoughts on Deferred Tax Liabilities and Float when it comes to valuation.

Today, we take a step back to explain what investment float actually is.

In 2016, I did an in-depth study of investment float and shared what I learned with readers about this incredibly important but unknown concept.

In this 8 – part series called On Float, you’ll learn the following things:

• What float is
• Why is it 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 I’ll answer the question, is float ever bad?

I hope you enjoy this series.

Jason

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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 post, Charlie Munger On Deferred Tax liabilities and Intrinsic Value – On Float Part 1 and we’re going to answer the question today – what is float?

But before we get to that, next is an excerpt from the July 2015 Press On Research issue where I talk about float extensively.

Warren Buffett’s admired around the world for his philanthropy as he’s going to donate 99% of his $70 billion plus net worth to charity when he dies.

He can donate so much money because of how great an investor he is. But almost no one knows how Warren Buffett made his fortune.

Yes, most investors know about his investments in Coke (KO), Johnson & Johnson (JNJ), and Wells Fargo (WFC). But this isn’t how he built his fortune.

Investor’s who’ve studied Buffet know he built his partnership, and then Berkshire Hathaway, buying small companies.

But this still isn’t the true secret to Warren Buffett’s success.

Today, I’m going to tell you how he grew $100,000 into more than $70 billion. And tell you how we can start doing the same.

But before we explain the exact companies Buffett built his fortune on, we need to talk about why Press On Research concentrates on small caps.

A University of Kansas student asked Buffett about this in 2005:

“Question: According to a business week report published in 1999, you were quoted as saying: “It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”…would you say the same thing today?”

Here’s Buffett’s answer, emphasis is mine:

“Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today’s environment because information is easier to access.”

Yes, I’ve said this before many times. But it’s an important concept to understand.

Small ultra safe investments that produce a ton of cash, have little to no debt, pay dividends and buy back shares, and are cheap and my favorite investments.

These kinds of businesses are what Value Investing Journey and Press On Research is all about.

Today’s recommendation has no debt. Owns more cash and cash equivalents than its entire market cap. And just its net cash and cash equivalents make up 77% of its market cap.

This doesn’t count any of its property, plant, and equipment, future premiums earned, or cost-free float. And this company is undervalued by 29% to 70%.

But this still isn’t all… It’s also much more profitable than competition.

Today’s pick isn’t just a great company with all the above traits. It’s also in Buffett’s favorite industry to invest.

Most people won’t research insurance companies. I wouldn’t, early in my investing journey. And many professional analysts stay away too.

This is because insurance companies are hard to understand at first, and have new and confusing terminology to learn. And normal profit metrics don’t matter much for them.

But if you learn how to evaluate them, not only will you learn they’re easy to evaluate once you know what you’re doing. But you can use the same repeatable process on every insurance company. And Buffett has continued to buy into insurance – his favorite industry – constantly over the decades. And it’s why he’s so successful.

In reality, insurance companies are easy to understand.

Insurance companies take money – premiums, the insurance version of revenue – as payment for insuring things like businesses, equipment, health, life, etc.

The insurance company doesn’t have to pay you a dime of the money it earns over the years until there’s some kind of damage or theft of whatever’s insured.

When this happens they pay the agreed upon insurance rate out to the policyholder.

While the company continues to earn money – premiums again – it invests some of it so it can pay back your policy in the future. And also make a profit in excess of the amount earned, invested, and paid out.

If the company writes its policies and invests well over time, it will earn underwriting profits. And grow the assets it can use to write more policies and invest more money.

If it doesn’t, the company will go out of business when a major disaster strikes.

Think of insurance companies like investment management companies, but instead of only earning management fees. Insurance companies earn premiums on top of investment earnings.

These effects can double profits over time… If management is great at what they do.

The insurance business while easy to understand is one of the hardest businesses to be great at.

Other than being a low-cost operator like GEICO, owned by Berkshire Hathaway. There are no competitive advantages in this industry, and it also experiences wild swings of huge profitability than massive losses.

But if the company writes policies and invests money well over a long period they can grow to great sizes at almost no extra costs. The only new costs may be to hire more staff.

Insurance companies also hold the greatest secret in the investment world – float. This is how Buffett built his fortune, and how we’ll start to build ours.

But before we get to this, we need to know why float is so important.

Buffett began buying Berkshire Hathaway stock in 1962 when it was still a textile manufacturer, and when he still ran his investment partnership.

He bought Berkshire stock because it was cheap compared to the assets it had. Even though the company was losing money.

He continued to pour millions of dollars into Berkshire to keep up with foreign and non – union competition. But none of this worked.

In time, Buffett realized he was never going to make a profit again in the textile industry, so whatever excess funds Berkshire did produce, he started buying other companies.

The first insurance company Berkshire Hathaway bought was National Indemnity Company in 1967.

Since then Berkshire’s float has grown from $39 million in 1970 to $77 billion in 2013.

Float compounds like interest does if you use and invest it well. But not only does float compound, if you use it right it also compounds the value of the company that owns the float.

Since 1967 when Berkshire bought National Indemnity, Berkshire’s stock price has risen from $20.50 a share to today’s price of $210,500. Or a total gain of 10,268%.

This is the power of insurance companies when operated well. And today’s recommendation is an insurance company that operates the right way too.

But before we get to that I need to explain how float makes this possible.

‘Float is money that doesn’t belong to us, but that we temporarily hold.” Warren Buffett

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 liabilities.

MY UPDATED NOTE HERE… I’LL TALK ABOUT THIS MORE IN DEPTH IN A LATER POST AND DETAIL WHAT I MEANT TO SAY AND DIDN’T EXPLAIN WELL ENOUGH HERE.

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 loaned. And you can use this money to invest.

Using cost-free float to fund operations can improve margins by up to a few percentage points.

MY NOTE HERE: I’LL EXPLAIN THIS BETTER IN A FUTURE POST TOO.

The best way to explain why float is so important is with the following quote:

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of free – other peoples money – in highly productive assets so that return on owners capital becomes exceptional.” Professor Sanjay Bakshi adding to something Warren Buffett said about great businesses.
I said in last month’s issue: “When a company’s float / operating assets ratio is above 100%, it means the company is operating with “free” or cost-free money.”

But this isn’t true with insurance companies.

For an insurance company to operate on a cost-free basis it has to produce underwriting profits for a sustained period.

I look for underwriting profits of at least five years straight to consider its float cost-free.

And the company I’m going to tell you about today has earned an underwriting profit every one of the last 10 years.

When you come across companies that are able to do this on a consistent basis you should expect exceptional returns in the future.

This is because when a company operates its entire business on a cost-free basis, it means several things. 1) It’s a great business, 2) It’s an efficient business, And 3) float magnifies profit margins.

So what is this great company?

I go on here to detail the company I recommended – and bought for the portfolios I manage – in July 2016 to subscribers.

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.

These vary more but remember if the company doesn’t have to pay interest on the liability it’s float… Money the company has to pay later but in the mean time can use to invest in and grow the business.

Think of float as normal debt without the negative effects.

In the short to medium-term – long-term for most insurance companies – float while listed as a liability on the balance sheet should be considered an asset to the company. Why?  Because while the company owns the float it can use these “liabilities” to invest and grow the business.

How though?

Because while the company lists the liability on its balance sheet – and still owns the liability – it can use the float as positive leverage to grow the company or invest in other businesses.

Sometimes at a better than cost free basis as mentioned above… But we’ll talk about this in a future post on float.

Next up I’ll go through a company’s balance sheet to separate float from non float. And show you how to value and evaluate it.

What do you think of float at this point? Do I need to explain anything better? Let me know in the comments below.

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P.S. If you want to become a great value investor fast and at a fraction of the cost of a normal university, check out our new Value Investing 6 Week Masterclass.