According to the research paper "Buffett's Alpha" by Andrea Frazzini, David G. Kabiller CFA and Lasse Heje Pedersen, Warren Buffett (Trades, Portfolio)'s market-beating investment returns are "neither luck nor magic but, rather, a reward for leveraging cheap, safe, high-quality stocks."
The authors of the paper note that over the 30 years to 2013, Buffett's leverage was about 1.6-to-1 on average, and this is part of what has helped him outperform the market so significantly.
Stock picking has also helped, to some degree, the paper notes, but without leverage, Buffett's returns would be nowhere near as good.
Buffett's float advantage
With the term "leverage," the authors of the paper are referring to Buffett's use of insurance float to boost Berkshire Hathaway's (BRK.A, Financial) (BRK.B, Financial) returns.
Every insurance company has float, but it is how Berkshire uses its money that makes it stand out.
Most insurance businesses invest their float in low-risk securities such as corporate bonds and Treasuries. Berkshire has followed the same path, to some extent, but the bulk of its assets have always been invested in stocks.
At the 1996 Berkshire annual meeting of shareholders, Buffett likened the company's float to "a bank having deposits." He went on to add:
"When a bank holds deposits, on everything except demand deposits, there's an explicit cost, an interest rate attached to it. And, then, there are the costs of running the system and gathering the money which is — also must be attributed both to demand and time deposit. In the insurance industry, a similar phenomenon takes place in that policy holders give us their money at the start of the policy period.
So, we have, in effect, something that is tantamount to the deposits of a bank. But whereas the deposits of a bank, it's quite easy to calculate the approximate cost, in the case of the float that the insurance company has, you don't really know what the cost of that float is until all your policies and losses — policies have expired and your losses have all been settled. Well, that's forever, in some cases."
The cost of borrowing
In his 1996 letter to investors, Buffett laid out the cost of the float to Berkshire between 1967 and that year. In the years where the group made a profit from its underwriting operations, the cost of the float was less than zero. If an underwriting loss was reported, the cost of funds was calculated as being the value of the loss as a percentage of total float.
Between 1967 and 1996, Berkshire's insurance business reported a loss in 14 out of 29 years. The average cost of float in these loss-making years was 7.46%. When you throw in the successful years as well, I calculate the average cost of float between 1967 and 1996 was 3.6%, although that is only based on the cost of float in profitable years being zero (Buffett himself estimated the cost of float at zero between 1967 and 1996).
When you consider the fact that over this time frame, the average yield on long-term government bonds didn't fall below 5.5%, this is an extremely attractive cost of capital.
The bottom line
The low cost of float has been key to Berkshire's growth since 1967, and it is likely that it will remain so for the foreseeable future.
As Buffett described in 1967, Berkshire's float is a "very important asset" and investors should give "a lot of attention over the years as to what is happening in — with that asset as to both growth and costs."
It is also important to remember that this critical advantage is not available to most average investors, and neither it is available to most insurance companies. Berkshire's insurance businesses are one of a kind, and without them, Buffett's float would have cost a lot more.
Disclosure: The author owns shares of Berkshire Hathaway.
Read more here:
- Warren Buffett's Thoughts on Finding Good Managers
- Warren Buffett: It Is Not Always Worth Chasing After Growth
- Warren Buffett: Risk Is 'Inextricably' Tied to Time
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