Pandora – Fast Fashion or Fad Fashion?

What would you pay for a well-regarded, branded business that is expected to grow revenues and net income around 10% CAGR for the next 3-5 years with industry leading margins, high returns on capital, and low capital intensity?

And better yet, given that this business has low capital intensity, the company generates and distributes high free cash flows back to shareholders in the form of dividends and share buybacks, bringing total shareholder returns to 15%+ per year?

That’s Pandora (the jeweler) in a nutshell.

And unusually, Pandora trades at just 12.5x trailing P/E (~10.5x 1yr forward P/E) and 10x trailing EV/EBITDA (~8.5x 1yr forward) based on analyst estimates.

Were the multiple to revert closer to branded peers or the index as a whole, that would potentially add another 40-50% return. Realizing that over a 3-5 year period would add an additional 10-13% return per year, bringing total returns to 25%-30% CAGR.

Of course the natural question to ask is why the market doesn’t see or believe the story? It all comes down to durability of the core product.

A Brief History of Pandora

Pandora is a Danish jeweler that was established in the 1980s. Although it’s been around for quite a long time, the company’s modern formula for success did not come about until the early 2000s when Pandora launched the charm and bracelet product.

Pandora Charms.png

The bracelet forms the core of the product, but the charms is where the magic lies. Through the selection of charms, Pandora customers (almost exclusively female) can personalize their bracelets and switch it up depending on the occasion. Today, Pandora carries a catalogue of more than 700 different charms, covering nearly every occasion and personal taste imaginable.

Through this product, Pandora embarked on a fantastic journey of growth with revenues expanding >12x between 2008 and 2016.

Pandora Revenue Growth.png

Pandora Today

Today, charms makes up ~60% of revenues with another ~20% coming from bracelets. The remaining 20% is composed of rings, earrings, and necklaces – categories that were mostly launched after 2013 in order to expand Pandora’s portfolio.

Pandora sells through 3 formats – concept stores, shop-in-shops, and multi-branded. Concept stores are standalone Pandora stores where the customer experience is designed and tightly-controlled by the company. Over the past few years, Pandora has been shifting the mix from predominantly shop-in-shop and multi-branded towards concept stores.

And layered on top of the channels, Pandora either runs the stores themselves or acts as a franchisor. Currently, 38% of revenues are generated through Pandora owned concept stores while the remainder is generated by franchisees or 3rd party distributors. In owned stores, Pandora captures the full retail price, while in franchise/3rd party stores, Pandora sells into those channels at a wholesale price. The difference is 2.4x (i.e. $100 worth of wholesale goods would fetch $240 if sold within owned stores).

Charmed or Cursed?

So far, the charms business has performed exceptionally well. Not only has it attracted a large customer base, it is also distinctly Pandora, which is an unusual feat of differentiation in the jewelry business. Jewelry tends to be a fairly commoditized industry (the inputs are commodities and final products are usually not distinguishable across brands) so product differentiation is usually non-existent except perhaps in ultra-high-end jewelry.

But that is exactly the paradox here – Pandora is not an ultra-high-end jeweler (Pandora’s price points are $25-$200), and the company sells a product that is quite non-traditional for a jeweler.

The prevailing thinking is that Pandora charms are a fad. One day customers will get over it, and sales will plummet. 

This fear has percolated for a decade, but over the past 12 months, the fear seems to have materialized. Reported like-for-like sales slowed across all regions with the most recent numbers in North America turning negative (this was partially compounded by confusing metric calculations, but I’ll refrain from discussing the nuances to avoid complexity). As a result, the stock has declined approx. 1/3 over the last 12 months.

In essence, the market appears to assume that Pandora is cursed, and one day investors will wake up to find that the charms business has been nothing more than a passing illusion. 

What Makes a Fad?

I challenge that view. Certainly there will come a day in which the charms business will be fully mature, but the performance of the charms business does not carry the usual characteristics of a fad.

For one, Pandora has been selling charms since 2000. If charms were a fad, the customer base would have likely moved on many years ago, yet the charms business still exists 17 years later. If this were a fad, it would certainly be the longest living fad.

Pandora recently conducted a survey of former customers and discovered that many customers remain interested in the brand and would consider buying Pandora products even after 6+ years.

Pandora Customer Consideration.png

In addition, fads usually tend to develop within certain groups (e.g. teens) or geographies. Yet, neither of these are observable within the Pandora customer base. Pandora charms and bracelets are worn across the age spectrum, and Pandora’s products are finding success across the world from the US to Latin America to the UK to continental Europe to Australia and to Asia. The global success of the product suggests broad appeal, and such broad appeal does not suggest a fad. 

A Fast Fashion Business Model

Rather than getting hung-up on whether the product is a fad or not, I think it’s more instructive to think about the business model and how the company operates.

At its core, Pandora is a fast fashion jeweler. Unlike traditional jewelers that have inventory cycles longer than a year and glacial lead times, Pandora’s inventory cycle is less than a year and lead time is only ~100 days. The company is targeting lead times of just several weeks by the end of this decade. Like Zara, the fast fashion retailer, Pandora can respond relatively quickly to customer preferences and adjust the product mix as the data prescribes. No one worries that Zara can’t sell fashion because when they do have a fashion miss on their hands, they can respond and fix the issue within weeks. Pandora is positioned similarly in the jewelry world.

Pandora sells fashion and newness, not “forever”Diamonds are forever. Pandora doesn’t do diamonds. What Pandora does do is drop 7 collections a year. Every season and holiday brings a new collection, a new reason for customers to pop in and see what else they can add to their collection, in effect creating a recurring customer/revenue streams. Given the low prices, charms are priced to be impulse purchases.

In addition, Pandora is a branded affordable jeweler. Investors and pundits seem to have a tendency to compare Pandora to other branded jewelers, which tend to be higher end. Pandora is no Tiffany. Pandora’s true competitors are mom & pop jewelers. Pandora offers customers a good brand, attractive products at an affordable price, and fashion – everything that mom & pops do not have the scale to offer.

If we consider the business model, it seems more than likely that if charms truly were declining, Pandora has the right business model to quickly adjust and adapt to whatever is next. 

What If I’m Wrong

Pandora is already priced as if the business will cease to exist in 10 years. That’s a fairly large margin of safety given that analysts expect the business to continue to grow at 10% CAGR for the next few years, but a couple of other things offer additional comfort:

  • Jewelry as a category is growing ~5% per year. If Pandora’s above-average growth simply normalized to industry growth, you would still have an okay business for the share price available today.
  • Pandora’s newer categories are growing >50% per year. In just about 3 years, Pandora has launched and grown non-charms/bracelet categories that now represent 20% of total revenues. Within a few years, these categories could represent 40-50% of total revenues, significantly reducing the dependence and fear of charms.
  • If worst comes to worst, Pandora’s continued conversion of franchise stores to owned stores would keep revenues unchanged even if the entire charms business goes away since owned stores generated 2.4x more revenues on an apples-to-apples basis compared to the wholesale channel. 

So the risk/reward looks pretty good to me.

Disclosure: I have no direct beneficial interest in PNDORA DC as of publishing date but I may initiate a position within the next 48 hours. 

A Publicly-Traded Airline “Float” Company

The last post, How Airlines Generate Float, compared the similarities between airline mile programs and insurance companies. I argued that airlines are now essentially generating float through their miles programs. Turns out it’s not that original of an idea (as much as I wish it was!) as there are at least two publicly-traded mile program managers in Brazil.

Smiles

One of these mile program managers is Smiles (SMLE3 BZ). Smiles actually directly calls out the “float” element of their revenue stream.

Smiles Revenue Streams

In essence, Smiles derives its revenues via the following ways:

  • Mile Sales – Smiles sells miles to program partners (e.g. airlines and banks). Partners give these miles to customers as a way to reward loyalty such as through airline frequent flyer programs and credit card points. From Smiles’ perspective, mile sales generate revenues as well as a future obligation to honor mile redemptions.
  • Float – Since mile redemptions occur months or perhaps years after customers earn/purchase miles, Smiles’ business model generates float. Like Berkshire’s insurance businesses, this float is carried as a liability but can be used/reinvested by Smiles to generate further revenues.
  • Breakage – And lastly, breakage, which refers to the revenues that is recognized from miles that expire/are never redeemed. Note this is primarily an accounting concern (earned when miles expire), while from a cash flow perspective, there is no  additional cash inflow associated with this revenue.

Smooth Sailing Through Stormy Skies

So how does this type of business model perform? Quite well actually.

Below are recent performance figures pulled from the latest Institutional Investor Presentation (March 2017). Despite the deep recession in Brazil and challenged airline industry, Smiles has been able to grow EBITDA margins over the last 2 years. 3Q14 – 1Q15 appear to have been the most challenging periods over the last two years (which saw earnings pressure), but the company appears to have been able to adjust fairly quickly and return to 40-60% YoY earnings growth by mid-2015. That is remarkable.

Smiles Performance.png

One other thing I’d point out is the growth rate differential between miles accrual and miles redemption (both ex-Gol, more on this in the next section). Except for the last 3 reported quarters, miles accrual growth rates far exceeded miles redemption growth rates. However, even though miles redeemed has been out-growing miles accrued, miles accrued is still growing faster on an absolute basis because it is a much larger number. Smiles references a “burn/earn” ratio, which came in at ~80% in the last Q. The faster growth in miles accrued vs miles redeemed is something that I argued would likely be the case in my previous post, and it is an important factor in driving the growth of float.

Finding the Pocket of Turbulence

As wonderful as this business appears to be, there are reasons why this company trades at only 14x LTM P/E despite a 6.7% dividend yield, HSD-to-teens revenue growth, and MSD-to-HSD EPS growth…

The largest concern is around Smiles’ ability to control its own destiny since it is closely linked to Gol, one of the largest Brazilian airlines. In fact, Smiles was created from within Gol to operate the miles program. A very significant proportion of Smiles miles is redeemed for Gol flights, and thus the value of Smiles miles is highly dependent on Gol’s operations. Unfortunately, Gol is highly levered and not particularly profitable. To make it more complicated, Gol remains a 54% owner of Smiles.

Although Smiles has operated admirably well during the recent recession in Brazil, Smiles’ equity hit major pockets of turbulence as Gol’s fortunes rose and fell.

But there is always a price. What price is appropriate for this kind of a business model if the company is not fully in control of its own destiny?

Concluding Thoughts

Smiles has a fascinating business model and validates a number of arguments in my prior post.

But I do wonder about two things:

  1. What is this type of business mode capable of if the float is used for investments similar to how Berkshire reinvests insurance float (or excess cash flows generated from his operating businesses)?
  2. Although airlines have attractive miles programs that generate float, they are used to finance cyclical operating businesses that have been prone to irrational competition. Although Smiles is a publicly-listed miles program pure-play, it is not free from the influence of an associated operating airline business. Would it be possible to isolate the advantages of the miles program and limit the exposure to the pure operating business?

Disclosure: I have no direct beneficial interest in SMLE3 BZ as of publishing date and have no intent to initiate a position within the next 48 hours. 

 

What Apple, Google, and Facebook’s Business Models Tell Us About Their Ability to Adapt to the Coming AI-Future

 

Judging from market multiples, it’s clear the market is skeptical of Apple’s ability to continue to succeed and has been for many years (currently, 1-yr forward P/E of ~15x despite recent re-rating), while holding limited concern for Google and Facebook (both 1-yr forward at ~26x).

This concern is understandable given the ever-changing tech environment and the long list of tech companies that have been buried over time (e.g. Nokia, Blackberry, Motorola). Even industry stalwarts of the bygone PC-era such as HP, Dell, and even Intel/Microsoft now stand on far weaker ground. And this concern for Apple is not new as Horace Dediu points out at Asymco

However, I contend that Apple’s business model is far more robust than Google’s in the coming artificial intelligence (AI)-revolution. 

Leaving aside potential differences in technical competency, AI is likely more complementary to Apple’s business model, but potentially highly disruptive to Google’s.

And to understand why, it requires understanding the job-to-be-done for search users and how Google’s ad-centric business model fits in.

The Assumptions Behind Search

Let’s start with the user – why do Google users search? What is the job-to-be-done?Seemingly simple question with a straight-forward answer: We are curious about many things and don’t have perfect knowledge. Google can help us answer what we don’t know. For most of Google Search’s existence, the service has approached this job-to-be-done by returning a curated list of search results that are most likely to match what the user is looking for. These are organic results that are designed to improve over time as the algorithm takes into account the answers/results users found most useful in the aggregate. Fairly simple and straight-forward.

So now turning to the business model – Google Search makes money on the ads that appear alongside search results. Every click on an ad (as opposed to an organic result) generates a small bit of revenue for Google.

Under what circumstances would a user prefer an ad over an organic result? 

Philosophically, Ben Evans (A16Z partner and almost always more than a few steps ahead of the curve) hits the nail on the spot:

In essence, the existence of ads on Google Search is the most egregious effigy to the failure of the underlying search algorithm. Every time a user clicks on an ad, it is an implicit acknowledgement that Google Search did not accomplish its job-to-be-done, that the desired answer would not have been provided had the advertiser not paid for that placement.

Given a long enough time horizon, if Google Search is truly improving, barreling towards a future where Google can answer any question without doubt and with perfect context, Google’s business model would have to evolve because ads do not have an obvious place in that future. 

And that future is coming closer with the advancements in AI. 

Search and AI

What could search look like in an AI-driven world?

It might not look all that different – perhaps Google’s I’m Feeling Lucky option or the knowledge graph cards.

But, it could also be radically different such as the search results provided by assistants such as Apple’s Siri or Amazon’s Alexa.

Regardless of the ultimate direction, it’s clear that ads have a far less obvious place in this future. If AI can be used to surface the right answer the user needs, the user would have less of a need to click on an ad.

I think we’ve seen the first instance of this issue with Google’s recent Beauty and the Beast ad on Google Home. The Google Home assistant (like Alexa) does not offer a natural channel for ads, and as a result, Google will have to find increasingly creative ways to adapt their business model for the changing environment. But history is filled with examples of failed business model surgeries.

It also makes Google’s persistent pursuit of a hardware/software business model a la Apple much more understandable. Perhaps selling hardware isn’t just about protecting access to market (after all, it’s unlikely that Android will be unseated now that it is so entrenched, so why continue with the direct hardware efforts?), it could be a deliberate attempt to evolve their business model to ensure financial relevancy in the AI-driven future.

Why Investors Seem Complacent

I contend that investors (or analysts) are confusing two separate concepts to be the same thing – the universal desire to know (hence search) and the need for ads to provide that information.

There is no doubt that search queries will only grow. It’s not farfetched to imagine a future where there are 7 billion search users instead of the less than 2 billion today. But that’s a far different conclusion from assuming Google’s financial future and business model are robust as long as search queries grow.

Search is robust, but are ads robust relative to our AI-future?

Apple’s Business Model is Far More Complementary to AI

Apple’s business model, on the other hand, is much more aligned. Sell the best products available for customers’ job-to-be-done.

AI is not orthogonal to this pursuit and business model. The only question is whether Apple has the technological capabilities to do so. However, even under the assumption that Apple is not the leader in AI-technology, it is not clear that it matters. After all, Apple was not the original leader in GUIs (Xerox PARC was). Apple was not the original leader in phones (Microsoft, Palm, Blackberry, Nokia, etc. were). Despite not being the original leader, Apple had the business model and insight to ensure that they could ride the underlying technological trend, and if I were to take a bet today, I believe Apple’s business model makes them more prepared to usher in an AI-world than Google is. AI is a feature to Apple. AI is a potential danger to Google’s business model.

From a business model standpoint, Apple is far more robust in an AI-world.

What About Facebook?

Facebook’s an ad-driven business model. What about them? Surely, Facebook is potentially in danger as well.

Facebook’s situation is less clear cut because the job-to-be-done for users is different vs search. Search has a “right” set of answers. Facebook’s feeds do not. Users are not necessarily searching for anything specific but rather using the services as an outlet for time. The “wrong” answer in a search query is far more obvious than a “wrong” answer in a Facebook feed.

And if AI can be used effectively to ensure that organic content on News Feed, Instagram, etc. are more relevant and engaging, then perhaps that can even offset any deterioration in experience from an increase in ad load. AI can never make Google’s organic results more engaging to the point where a user will tolerate a less user-friendly ad environment.

Facebook’s job-to-be-done is to, cynically, offer a time sink. Google’s job-to-be-done is to get you your answer as fast as possible. One of these is more complementary for an ad-driven business model. 

Concluding Thought

Is Google as robust as investors think? Borrowing from Peter Thiel – is this something that could be true that no one believes? Is Apple in as much danger as the average person believes?

Disclosure: I have no direct beneficial interest in AAPL, GOOGL, or FB as of publishing date and have no intent to initiate a position within the next 48 hours. 

Simple Investment Theses

“A further related lesson: Easy does it. After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.” -Warren Buffett, 1989 Berkshire Letter to Shareholders

The investing industry is a bit of a head-scratcher: it’s the only industry I can think of where complexity is celebrated (on average). And that is unusual because complexity can lead to poor long-term investment results.

For example – Valeant, SunEdison, Ocwen, non-vanilla banks with complex derivative books, Enron…etc.

With hindsight, it’s clear complexity didn’t work out favorably and really begs the question of whether that complexity was worth the forecasted potential returns. And that question is even more pertinent when taking into consideration that Buffett has performed admirably well with a basket of investments where complexity is anathema.

There are more than a few problems that arise with complexity:

  • Investors may be stepping outside of their circle of competence without knowing it
  • Complex situations require a lot of work, and after having done all that work, an investor is likely to fall prey to elevated confidence
  • Lots of moving parts means lots of things can go wrong (and perhaps lots of things need to go right for the investment to work out)
  • Unless an investor is going to take the target private, eventually the investor needs to sell the investment to someone else – who else is going to understand and want to own that complexity?

Of course the reason the industry gravitates towards complexity is because there are too many smart people analyzing investments. And one way to obtain (theoretically) better investment results is to understand progressively complex situations where other smart investors cannot follow. I also believe there is a perverse incentive to seek out complex situations because a successful analysis really massages the ego. After all, the investment industry is really an intelligence / knowledge business…

To close the loop, seems to me the investment industry as a whole has adopted complexity as an investment strategy and business model. This worked when the industry was nascent, but now there are too many smart people all doing the same thing. Complexity as an investment strategy and business model is probably past its prime. How would an investor adapt to this new environment?

The Importance of Focusing on Business Models

“Investment is most intelligent when it is most businesslike.” – Benjamin Graham

“I am a better investor because I am a businessman and a better businessman because I am an investor.” – Warren Buffett

Most investors define themselves along a couple of axes: Technical vs fundamental, value vs growth, long vs (and/or) short, contrarian vs momentum, large cap vs small cap, etc. These labels are well understood and established conventions.

However, these labels distract from what is most important when it comes to investing – an understanding of the underlying business.

Whether you are a fundamental investor, a value investor, a growth investor, a contrarian investor, all of these labels serve only to illustrate the “how” and not the “what” or “why”. It seems remarkably odd that few investors refer to themselves as a Business Model Investor, which I believe is a much truer expression of the essence of investing.

The Benefits of Focusing on Business Models

Though I bear the risk of promoting myself to Captain Obvious, I think it’s important to call out what’s important – investing is most likely to succeed when we think of ourselves as buying businesses, and buying businesses entail understanding the business model and how it works.

I believe this is distinctly different from just understanding a company’s products, describing Porter’s 5 Forces, and assessing strategic vision / management.

Understanding business models can help us uncover great companies with sustainable businesses that otherwise may not be apparent. 

The Scourge of Retail

Today, most investors understand Amazon’s outsized impact on traditional brick & mortar retailers including the venerable Walmart. But it was not that long ago that many assumed brick & mortar would be able to leverage their larger scale (at the time) to ward off Amazon and other threats. Surely, Walmart with all its might and low prices can take the fight to Amazon if it wanted to. And of course, brick & mortar had the benefit of strong earnings / cash flows, whereas Amazon had none of the 1st and few of the 2nd (still has essentially no earnings today but cash flows are a massively different story). These were prevailing views just 3-4 years ago.

I think this is a perfect example where business model investing has been far more fruitful. All of the traditional retailers did have a scale advantage (not anymore), but scale is not a business model. Scale is merely a competitive advantage, and a disrupt-able one against a well-funded competitor.

Amazon has the benefit of a better business model. It’s a retailer that did not have to carry the significant costs associated with physical stores or sales staff. From a  business model investing perspective, it takes just a few words to understand Amazon’s advantage. These advantages are not as easily understood from just looking at historical financial statements (of which earnings look terrible and earnings-based ROIC looks laughably poor). Understanding these advantages require thinking of the business model holistically.

Finding the “Most Valuable Company in the World” in No Man’s Land

Apple, the most valuable company in the world, is a curious case. It continues to thrive in the metaphorical graveyard of tech. Few companies have survived (and thrived) for long in tech hardware because the fundamental forces at work are overwhelming – commoditized products, persistently declining prices (not least driven by Moore’s Law), fragmented landscape with too many competitors to count…Generally a terrible industry. And all of these elements are likely to remain true for the foreseeable future, leading many investors to make the case that sooner (and perhaps rather than later) Apple will succumb to the same forces that has brought down Nokia, Motorola, HP, etc.

But that view ignores Apple’s different (and unique) business model within the tech hardware industry.

From a consumer perspective, Apple’s business model is simple – sell highly-designed, premium products where every element / component is customized for use.

But from a strategy standpoint, Apple’s business model is secrecy. Whereas Apple’s peers like to run their companies like scientific experiments in broad daylight, Apple’s business model is to play the cards close to their vest. Is it any mystery then why Apple has been and will continue to be a disruptor of the industry? Nearly everything that can potentially disrupt Apple is brandished in broad daylight years before the hero’s blade is finished forging. Apple knows what’s coming from nearly everyone else, but does the rest of the industry know what’s coming from Apple?

And how does this business model address the overwhelming forces of the tech hardware industry? It allows Apple to differentiate their products with non-commoditized hardware, which can be monopolized for a (short, e.g. 1 year) period of time. Apple has to keep fighting these forces, but it’s a perpetual 1 year advantage until ideas run out (and the human race has demonstrated for 10,000 years that there are many more ideas than we can pursue).

Apple’s vertically-integrated product model also has the advantage of getting innovations to customers far faster than peers. Google is a very able peer in the smartphone OS space, but their innovations are taking on average about 3 years to get into customer hands. The majority of their customers are still using an OS that shipped in 2014 or earlier.

One should rightfully assume that tech hardware is a tough space, but from a business model perspective, it’s easier to see that Apple plays a different game and should have been apparent long, long before Apple became a household name or the world’s most valuable company.

Business Model Differentiation Worth More than “Competitive Advantages”?

One idea that I’ve been turning over in my mind is the importance of having a differentiated business model rather than just pure “competitive advantage”. After all, BHP and Rio Tinto have the unbreakable competitive advantage of immense scale in an industry where large mines cannot be willed from thin air through cash alone. But I do not think it is a stretch to say that BHP and Rio Tinto do not have differentiated business models and are bystanders to the same industry forces that buffet their peers.

Are differentiated business models the most important thing? 

 

 

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.