Berkshire’s Performance Edge that No One Talks About

Over the last half century, Buffett has achieved a marvelous long-term performance record. Many have studied and written about his investments to try to learn how to replicate what he did.

I’ve read a lot of those, and you probably have, too. But I’ve always felt that something was missing. 

Consensus has generally coalesced around a couple of observations on how he’s done it:

  • Buffett focuses on high-quality businesses (but will settle with a partial interest via public equity if he can’t own the whole thing)…
  • Purchased at fair (or cheap) valuations
  • And never letting cash burn a hole in his pocket as he waits patiently for these opportunities

He also appears to have a preference, either by choice or happenstance, for stocks that generally exhibit lower beta.

All of these elements are widely known and well understood (whether it is practice or not is a different story).

More recently, there’s been a greater focus on Buffett’s use of leverage. Since the core of Berkshire is composed of insurance companies, Buffett has benefited from the embedded leverage of those operations. This leverage is generated through the float that Buffett oft sings the praises of.

One of the most detailed (academic) treatments is Buffett’s Alpha by Frazzini, et al. where the authors estimate an embedded leverage ratio of 1.6:1. Through this leverage, Berkshire has been able to take low-beta, high-quality compounding businesses with good returns and generate great returns.

But this has always struck me as too simplistic. After all, many have tried leverage before to terrible ends. Many hedge funds today also have (re)insurance businesses to generate float, but these operations only share conceptual kinship rather than the true underlying essence of what makes Berkshire’s insurance operations great.

The Missing Ingredient?

“History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.” – Berkshire Letter to Shareholders, 2011

“If you don’t have leverage, you don’t get into trouble. That’s the only way a smart person can go broke. I’ve always said if you’re smart you don’t need it and if you’re dumb you shouldn’t be using it.” – Buffett remarks to Financial Crisis Inquiry Commission, 2010

Seems to me the key for Buffett has been taking on leverage while avoiding the downside of leverage. And Berkshire’s insurance core has been the perfect structure to mitigate leverage risks.

There are 2 major problems with traditional leverage: 1) Capital calls at an inopportune time, and 2) Magnification of losses forcing investors to exit positions prematurely.

At Berkshire, float is generated through insurance and reinsurance premiums tied to autos and, generally, “catastrophes”. It’s clear that leverage generated through these avenues are likely to exhibit lower correlation to the general business cycle. People are generally more reluctant to default on autos than on homes, and the timing of major natural disasters are independent of recessions. Not only do these qualities limit the potential of inopportune capital calls, it likely ensures the availability of capital at an opportune time – the bottom of a cycle / recession. 

One can argue that the risk of leverage has not been eliminated, merely offset from the business cycle. After all, he will eventually need to pay out claims. Although this is true, Berkshire’s insurance businesses not only earn underwriting profits, they also generate more float/premiums than they pay out in claims in a majority of years (i.e. cost-free float and negative working capital). With growing float/premiums, losses can be backed with future premiums. The value of this advantage cannot be understated – imagine what you could do with leverage if you knew that it would never have to be paid back or know with high assurance that you can pay it back with future cashflows. This increases what looks like limited duration capital (say 3-5 years for auto float) to far-longer (dare I say permanent?) duration capital.

How about magnification of losses?  At face value, the growing mix of private / full-ownership businesses at Berkshire limit the need to mark-to-market. This materially lowers the risk of having a noxious combo of leverage and paper losses. But, this is a trickier thing, which I am inclined to think there are other secrets that I have yet to understand.

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