OH YEAH HOW’S THAT FOR A TEASE KIDS?
I like to imagine Warren Buffett clicking around the internet and getting appalled at the number of people who use him as a reason to invest a certain way.
Value investors love Buffett, of course, even though he hasn’t made a true value investment in decades. Dividend-growth investors also think the guy approves of their way of investing because he owns a lot of the same stocks DGI folks do. Even index investors think Buffett is on their side, despite the man’s legacy basically being a giant middle finger to index investing.
And so on. One of the best (and worst) things about the average Warren Buffett quote is it’s vague enough that anyone can take a little something out of it. It’s like a terrible horoscope.
The world is also filled with articles and books explaining Buffett’s investing secret. This ends up being a lot of different things. Some say it’s because he’s the best thinker. Others say it’s because he works the hardest. Some attribute his success to patience. I’ve even heard people claim Buffett’s success is because he’s an honest and decent guy.
Those all attributed to Buffett’s success. But there’s one thing that stands above the rest. Buffett’s biggest investing secret is actually pretty simple and is something you can easily replicate. Almost.
The power of insurance float
Most retail investors don’t understand this concept correctly. There are a lot of pros who don’t really understand it either.
Insurance is a simple business that can be difficult to execute. A bunch of people send premiums to a company. As long as the company can pay out less than what it takes in over time it’ll be profitable.
An insurer will have a ton of money just kicking around, waiting to get paid out. This is referred to an insurance float. Most insurance companies invest this money in bonds, eager to keep their risk down.
Berkshire Hathaway didn’t. It invested its float into undervalued stocks.
An insurance company can really accelerate float generation by posting a positive combined ratio. That means it’s a profitable operation before investing any of its premiums.
A simple example: an insurance company takes in $100 in premiums and only pays out $95 in claims. That gives it a combined ratio of 95. It then invests that money at 5%, earning another $4.75. Combine the two and you have a pretty attractive business.
When Berkshire Hathaway first got into insurance in the 1970s and 1980s, insurers didn’t care as much about combined ratios. If you could take in a premium and invest it at 10%, you really didn’t care if your combined ratio sat at 101 or even 105. You were still making money.
Buffett wanted none of that ish. Berkshire was always a very selective insurance underwriter. If it didn’t like the risk, it would just exit the market.
How float can work for you
Now that you know how float works (or you skipped the learnin’ section), let me explain the net impact of float for Berkshire Hathaway.
It was the equivalent of having about 25% extra capital for free.
I bolded that for a reason. Imagine you had $100,000 to invest. And then somebody gives you $25,000 with the instructions that you don’t have to pay any interest and you won’t have to pay it back. And as your investments grow, so will the loan.
That would be the greatest loan in the history of the world. You’d take it in a heartbeat.
Let’s illustrate the power of this using a very simple example. Say you had $10,000 to invest and added $10,000 per year. You earned 10% per year. How much would you have after 40 years?
Now let’s run scenario B, which approximates the impact on Berkshire’s insurance float over the years. Instead of adding $10,000 per year, I’ve added $12,500.
That’s a considerable amount more money. And all we did was take on 25% leverage.
It’s not even an accurate representation of float, either. The amount invested was constantly going up, further increasing the compounding effect. I’ve just assumed the earnings from the insurance business stayed flat. Berkshire’s insurance business slowly got bigger over time.
There’s a safe way for investors to replicate float, although you won’t get the advantage of an interest-free loan. All you need to do is borrow 25% of the value of your portfolio at all times.
This adds to your investable capital without taking a huge amount of risk. And as long as you’re smart about borrowing (spoiler alert: use Interactive Brokers) and maintain a 25% leverage rate, you won’t run into any problems. Even if the market does a 2008 again.
Wrapping it up kids
Warren Buffett’s biggest investing secret is as simple as it is powerful. All an investor needs to do is find a free source of leverage and use it to their advantage. Free sources of leverage don’t exist for those of us without insurance operations (or generous relatives), but we can get pretty close. Do that, and then maintain it, and you’ll end up with more money come retirement time with just a little extra risk.
Buffett did it. You might as well too.