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The Crocodile of the Moat: The Float (Part I)

January 04, 2014 | About:

Recently I have been enamored in fascination with how well Warren used floats over the course of his lifetime. I have been thinking about how various floats are linked to dominant firms and their economic moats. Looking for metrics like negative working capital, negative cash conversion cycles, derivatives, profitable insurance underwriting, deferred taxes and other payables that may or may not materialize and how they produce tactical leverage. I will be going through the various major and minor floats that I have been able to identify. The closer the float approaches a cost of zero and a duration that approaches infinity, the more it resembles a perpetual zero coupon bond.

“Any company’s level of profitability is determined by three items:  (1) what its assets earn; (2) what its liabilities cost; and (3) its utilization of “leverage” — that is, the degree to which its assets are funded by liabilities rather than by equity.”

Warren used the words funded by liabilities rather than debt, and we should think of the float as a form of leverage, as it is other people’s money. Unlike debt, float is not financed by interest payments and unlike equity offerings; it will not dilute current shareholders. It is the best alternative source of financing. 

1. Deferred Taxes

Deferred taxes arise when the accounting books show different income than the tax books (allowance for debt, inventory, restructuring, depreciation charges and/or capital gains). Deferred taxes may also arise when marketable securities have market values that are higher than acquisition or book value. Warren Buffett long ago realized deferred taxes were an interest free form of financing as depicted by his relentless harping of long-term holding periods (due to both tax and compounding benefits) and Berkshire’s 2012 deferred taxes liabilities of 53.6 Billion.



Buffett illustrated very simply in his 1989 shareholder letter the benefits of deferring tax liabilities over a long period of time versus paying annual dues and the power of compounding the interest free U.S Treasury loan into his own equity.

“Imagine that Berkshire had only $1, which we put in a security that doubled by yearend and was then sold. Imagine further that we used the after-tax proceeds to repeat this process in each of the next 19 years, scoring a double each time. At the end of the 20 years, the 34% capital gains tax that we would have paid on the profits from each sale would have delivered about $13,000 to the government and we would be left with about $25,250. Not bad. If, however, we made a single fantastic investment that itself doubled 20 times during the 20 years, our dollar would grow to $1,048,576. Were we then to cash out, we would pay a 34% tax of roughly $356,500 and be left with about $692,000. The sole reason for this staggering difference in results would be the timing of tax payments.”

The Berkshire Hathaway owner’s manual also states the “funding sources” (insurance float and deferred taxes) lead to more assets than the equity capital would permit (assets + liabilities = equity) and has had no costs, essentially an unencumbered source of value. It should also be noted that the two make up just over 108 billion of Berkshires float and are clearly major financers of value creation.

“Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets than our equity capital alone would permit: deferred taxes and “float,” the funds of others that our insurance business holds because it receives premiums before needing to pay out losses.

Better yet, this funding to date has often been cost-free. Deferred tax liabilities bear no interest. And as long as we can break even in our insurance underwriting the cost of the float developed from that operation is zero. Neither item, of course, is equity; these are real liabilities. But they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of debt – an ability to have more assets working for us – but saddle us with none of its drawbacks.”

Charlie Munger also explained to Wesco shareholders in 2007 that the deferral of taxes is not working in perpetuity for shareholders thus the present value of the deferred taxes must be valued lower, much lower, than stated. Albeit how much lower is a question we cannot answer with conviction, due to the uncertainty of future taxation policy as well as the time that will pass until the taxes that will be recognized. 

“Wesco carries its investments at fair value, with unrealized appreciation, after income tax effect, included as a separate component of shareholders’ equity, and related deferred taxes included in income taxes payable, on its consolidated balance sheet. As indicated in the accompanying financial statements, Wesco’s net worth, as accountants compute it under their conventions, increased to $2.53 billion ($356 per Wesco share) at yearend 2007 from $2.40 billion ($337 per Wesco share) at yearend 2006. The main causes of the increase were net operating income after deduction of dividends paid to shareholders, and appreciation in fair value of investments.

The foregoing $356-per-share book value approximates liquidation value assuming that all Wesco’s non-security assets would liquidate, after taxes, at book value.

Of course, so long as Wesco does not liquidate, and does not sell any appreciated securities, it has, in effect, an interest-free “loan” from the government equal to its deferred income taxes of $322 million, subtracted in determining its net worth. This interest-free “loan” from the government is at this moment working for Wesco shareholders and amounted to about $45 per Wesco share at yearend 2007.

However, some day, parts of the interest-free “loan” may be removed as securities are sold. Therefore, Wesco’s shareholders have no perpetual advantage creating value for them of $45 per Wesco share. Instead, the present value of Wesco’s shareholders’ advantage must logically be much lower than $45 per Wesco share.”

Essentially neither the (profitable) insurance float nor deferred taxes are worth their “book value” depicted on the balance sheet and would end up raising equity. Depending on the outcome, deferred tax assets (think NOL’s) or valuation allowances (essentially a subjective adjustment to DTAs) may also be created. For the sake of a beneficial float I would argue valuation allowances can be used to game earnings by some companies and the prior is an asset that should be discounted to (1+r) ^-n, (n being the estimated time the tax benefit will be received discounted at the cost of debt).

Deferred tax liabilities on the other hand (money you will have to pay eventually and our focus of the post) is not interest bearing, unencumbered and not paid in advance, so it may be utilized until an unspecified future date. This liability, in my opinion, is somewhere in between a non-existent liability and owners equity (call it no mans land) as the deferred tax will grow (and never be realized unless a sale is made) although the equity will grow at a quicker rate, as the cash is used to create more cash. The closer the float approaches a cost of zero and a duration that approaches infinity, the more it resembles a perpetual zero coupon bond.

Well, what would we value a zero coupon bond that never matures?

I would say zero, or very close to it.

Benefit upfront and (maybe?) pay later or benefit later and pay now?

2. Profitable Insurance Underwriting

Profitable insurance underwriting is by no means an easy feat (over a long time period) and takes very talented risk/probability analysis. It is characterized by the combine ratio, the losses + expenses divided by the premiums received. As long as the premiums received are equal to the losses and expenses incurred, the float will be free. If the combined ratio is under 100 the holder of the float has been paid to hold the float. Amazingly, Berkshire grew their float from 39 million in 1970 to 73.12 billion in 2012 and in 37 of the 45 years (ending 2011) the industry as a whole had an underwriting loss. Ajit Jain has done a terrific job for Berkshire over the years at GEICO and he and GEICO continue to be a crown jewel of Berkshire. Buffett explained insurance in further detail in his 1995, 1997, and 2011 letter excerpts below.

“Since our float has cost us virtually nothing over the years, it has in effect served as equity. Of course, it differs from true equity in that it doesn’t belong to us. Nevertheless, let’s assume that instead of our having $3.4 billion of float at the end of 1994, we had replaced it with $3.4 billion of equity. Under this scenario, we would have owned no more assets than we did during 1995. We would, however, have had somewhat lower earnings because the cost of float was negative last year. That is, our float threw off profits. And, of course, to obtain the replacement equity, we would have needed to sell many new shares of Berkshire. The net result – more shares, equal assets and lower earnings – would have materially reduced the value of our stock. So you can understand why float wonderfully benefits a business – if it is obtained at a low cost.

Since 1967, when we entered the insurance business, our float has grown at an annual compounded rate of 21.7%. Better yet, it has cost us nothing, and in fact has made us money. Therein lies an accounting irony: Though our float is shown on our balance sheet as a liability, it has had a value to Berkshire greater than an equal amount of net worth would have had.”

So how does this attractive float affect intrinsic value calculations? Our float is deducted in full as a liability in calculating Berkshire’s book value, just as if we had to pay it out tomorrow and were unable to replenish it. But that’s an incorrect way to view float, which should instead be viewed as a revolving fund. If float is both costless and long-enduring, the true value of this liability is far lower than the accounting liability.”


Remember: The closer the float approaches zero-cost and has a duration that approaches infinity, the more it resembles a perpetual zero coupon bond and will be an unencumbered source of value.

Part II HERE

About the author:

Tannor Pilatzke
I am a self taught investor through Warren Buffett, Charlie Munger, Ben Graham, Peter Lynch, Joel Greenblatt, David Einhorn, Seth Klarman, Howard Marks, Phillip Fisher and Thornton O'Glove. My focus is a bottoms up Value-GARP strategy with a mix of top down contrarianism.

"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain

Visit Tannor Pilatzke's Website


Rating: 4.2/5 (26 votes)

Comments

The Science of Hitting
The Science of Hitting premium member - 11 months ago

Good read Tannor - trying to learn more and more about this topic as time has gone by and you've helped me to get a bit further. Thanks!

Tannor
Tannor premium member - 11 months ago

Thanks for the kind comments Science. 

It is a very fasicnating topic and I do believe that when a "cost-less" float or a float that cost under the risk free rate is present, it is much like above average invested capital returns, there must be some type of moat present or compeitiors would begin to encroach on the cost-less float, much like margins and ROIC. I hope you also enjoy the second part of the article and look forward to hearing other peoples opinion/comments. The problem for smaller investors may also be accessing the float if/when it is established, ultimetly not able to choose how it is utilized.

Random Thoughts, 

Cheers.  

20punches
20punches - 11 months ago

Great article Tannor. Just want to clarify here on the deferred tax liabilities. I'm guessing in this article you are referring to the deferred tax liabilities related to investment gains right? Not the generic accounting deferred taxes liabilities that arise from perm and temp differences between the tax and financial books? Of course unrealized gains will cause such differences as well but are deferred taxes liabilities arise from other temp differences such as depreciation, intangibles amortization considered part of the moat? 

Tannor
Tannor premium member - 11 months ago

No problem Ning and thanks,

Both are hypothetically charecterized as a float that contributes to the moat if the depreciation is perpetual [enduring] or the company is in growth mode (meaning replacement and maintenace of fixed assets is expected forever or for a very long period), and the company is utilizing a higher depreciation rate for the tax books and a lower one for GAAP, although the articles main focus is on investment related gains for the sake of simplicity. It is essentially what I like to think of as government equity, allowing the business to grow with more cash (taxes they should have paid if GAAP was the same as the tax books)) than they would otherwise have. I should have focused more on the depreciation side in hindsight as it is a major contibutor to deferred taxes of most companies.

I hope that helps clarrify.

vgm
Vgm - 11 months ago

Terrific write-up, Tannor!

Prem Watsa has a similar situation developing at Fairfax where insurance float per share is almost 2x BV, making BV a very conservative estimate of intrinsic value. The cost of float was not zero but not far off (ca 1.1% average over 10 years) and he'd like that to be negative in future. 

Thanks for the stimulation. 

Tannor
Tannor premium member - 11 months ago

Thanks Vgm and no problem.

I completly agree!

Cheers.

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