Buffett’s Genius: Why Investing Is Just Part Of The Equation

I recently read a research paper in the Financial Analysts Journal entitled Buffet’s Alpha. Written by three of the principals at AQR Capital Management, a global investment firm based in Greenwich, Connecticut, the paper outlines a detailed analysis of Warren Buffett’s investment performance.

While much has been written about Buffett’s investment prowess, there has been very little quantitative analysis used to understand how he’s been able to compound shareholder capital at such an impressive rate for so long. The authors conclude that “Buffett’s returns appear to be neither luck nor magic, but rather the reward for leveraging cheap, safe, high-quality stocks.”

On the surface, this seems like a simple strategy to copy - borrow some money and buy some inexpensive, durable, large cap companies. However, it’s nearly impossible for others to use leverage to the same magnitude as Buffett does while paying as little as he does.

According to the paper’s authors, Buffett’s leverage is about 1.7:1 in terms of total assets to shareholder equity. In other words, Buffett gets $1.70 in total assets working for each $1.00 in shareholder equity. That’s like putting up 60% of everything you buy. What incredible purchasing power!

While Buffett often expresses his disdain for borrowing money to buy stocks, this is precisely what has made him one of the richest people on the planet. However, he has borrowed it in a very smart way, with very little risk, and at virtually no cost.

At the end of the last fiscal year, Berkshire Hathaway had approximately $123 billion in insurance float on its balance sheet. Traditionally, insurance float grows as insurance premiums grow and is the result of the timing between when premiums are paid by customers and when claims are paid by the insurer. Berkshire has long been a leader in “long tail” or “big float” insurance and has the largest float of any insurance company in the U.S. Unlike bank deposits, float can’t be easily taken away in times of stress.

Insurance float is not entirely without risk. Predicting natural disasters and other similar events is a tough job; estimating the financial losses associated with these events over a longer time period is even tougher. What distinguishes Berkshire from other insurers is its underwriting discipline and its ability to consistently generate positive underwriting profits. When underwriting profits are positive, Berkshire is actually getting paid to hold policyholder capital. In 2017, Buffett’s 14-year streak of consecutive underwriting profits ended abruptly as hurricanes and wildfires wreaked havoc across the U.S. Over the last 16 years, Berkshire’s pre-tax underwriting profits have totalled $27B and its pre-tax losses were approximately $2B.

Can you imagine being able to borrow large sums of money and then getting paid to do so? It almost sounds too good to be true. But this is exactly what Buffett does. He created a system that maximizes the amount of money at his disposal that he then prudently invests for the benefit of shareholders.

While Buffett’s returns on the investment side “appear to be neither luck nor magic,” his prowess for gathering massive amounts of ultra low-cost insurance float is his true stroke of genius and is the main reason why he has been able to generate such large returns for shareholders for so long.

It may sound simple and straightforward, but so far, very few people have been able to copy him.

Chris Blumas, CFA, is Vice-President, Portfolio Manager at GlobeInvest Capital Management Inc.

Article Reference: Buffett’s Alpha – Frazzini, Kabiller, Pederson; Financial Analysts Journal 2018: Volume 74 Number 4