My Modest Buffett Prediction

This excerpt from Alice Schroeder's "The Snowball" caught my eye. She writes of the 1973-1974 period [my emphasis in bold]:

But in the bigger picture, what Berkshire, Diversified, and Blue Chip [the latter two were eventually merged into Berkshire] really possessed were two things. The first was the homeostatic business model--the idea of grafting float onto a holding company so that it could respond internally to the changing environment. The second was the power of compounding, as float and investments doubled and redoubled over time.

The novelty and strength of Berkshire's model cannot be overstated. Nothing like it existed, or would for years to come. "That was the golden period of textbook capital allocation," he says.

The timing was stupendous. Capital from the insurance companies was pouring into Berkshire and DRC at the same time that the market was collapsing, the environment that Buffett liked best.

As I've argued before, the ability to spot undervalued investments, which many claim these days, is only half the story. The other half is having the capital available to do so. In the 1974 bear market Buffett nailed it perfectly--he hit on insurance float as a way to generate low-cost capital for investment just at the time great investment opportunities were emerging.

A modest prediction: Look for Berkshire to do it again this time around. I would not be surprised to see above-average growth in float, perhaps at the expense of underwriting profits, as Buffett looks to generate as much capital as possible with which to invest at favorable expected returns. In a world where it's almost impossible to borrow money in size from banks, the ability of a good insurance company to "borrow" from policyholders is a huge advantage.

A related point: In looking at current investment opportunities, I'm placing great weight on a company's ability to generate capital for reallocation purposes. That could mean cash already on the balance sheet, a high ROE, or the ability to borrow.

Comments

[Jolly_Rancher:]

Large oil companies have a lot of cash now. Why don't they do the same thing? Same for large drug companies. What makes insurance such a different source of capital that it can fund general market investment? Doesn't Buffett advise stearing clear of conglomerates, but isn't his Berkshire Hathaway a conglomerate? What makes his conglomerate different from say a GE? Didn't GE try the same thing with insurance and banking, that is, use the excess cash flow to fund investment in diverse businesses, including general equity investment? Finance tells us that the cost of capital is the same whether generated internally or through external mechanisms. Why is insurance float cheaper than oil or drug float or simply going to the bank and borrowing?

Feb 01 03:50 PM

[Ricard:]

"The timing was stupendous. Capital from the insurance companies was pouring into Berkshire and DRC at the same time that the market was collapsing, the environment that Buffett liked best."

That's quite an observation. I always assumed the float was a cheap form of non-callable margin, but this point is much more potent.

I've yet to read the book, but it seems like a winner if it can make subtle points such as this. Thank you.

Feb 01 08:26 PM

[auto44:]

The insurance float is borrowed from the insured at 0 interest.


On Feb 01 03:50 PM Jolly_Rancher wrote:

> Large oil companies have a lot of cash now. Why don't they do the
> same thing? Same for large drug companies. What makes insurance such
> a different source of capital that it can fund general market investment?
> Doesn't Buffett advise stearing clear of conglomerates, but isn't
> his Berkshire Hathaway a conglomerate? What makes his conglomerate
> different from say a GE? Didn't GE try the same thing with insurance
> and banking, that is, use the excess cash flow to fund investment
> in diverse businesses, including general equity investment? Finance
> tells us that the cost of capital is the same whether generated internally
> or through external mechanisms. Why is insurance float cheaper than
> oil or drug float or simply going to the bank and borrowing?

Feb 02 09:45 PM

[michaelservet:]

"Doesn't Buffett advise stearing clear of conglomerates, but isn't his Berkshire Hathaway a conglomerate? What makes his conglomerate different from say a GE?"
--------

Berkshire works at a different level on the value scale (eg, private < public share < control < synergistic) ... and Berkshire is a different kind of conglomerate. There's no 'conglomeration' or attempt at synergies (and conglomerate discounts don't apply). In other words, Berkshire has the ability - and has used it - to sell to synergistic conglomerates (its former Gillette and ABC units are good examples). It often buys companies at the lower end of the value scale (privately owned).

Of course Berkshire has other attributes, but Buffett's fairly unique value arbitrage formula is one. Instead, GE, JNJ, P&G etc, frequently 'pay up' for strategic purchases, then go for synergies -- hence a conglomerate discount would apply. Unlike Berkshire, there's no higher-level buyer for their units.

As to float...that's another relevant discussion (tomorrow's lesson)









On Feb 01 03:50 PM Jolly_Rancher wrote:

> Large oil companies have a lot of cash now. Why don't they do the
> same thing? Same for large drug companies. What makes insurance such
> a different source of capital that it can fund general market investment?
> Doesn't Buffett advise stearing clear of conglomerates, but isn't
> his Berkshire Hathaway a conglomerate? What makes his conglomerate
> different from say a GE? Didn't GE try the same thing with insurance
> and banking, that is, use the excess cash flow to fund investment
> in diverse businesses, including general equity investment? Finance
> tells us that the cost of capital is the same whether generated internally
> or through external mechanisms. Why is insurance float cheaper than
> oil or drug float or simply going to the bank and borrowing?

Feb 03 08:58 AM

[Buffett fol...:]

I totally agree that 'the ability to spot undervalued investments, which many claim these days, is only half the story. The other half is having the capital available to do so'. Buffett will be a shining star in the future, that's because he has so much cash in hand now.

Feb 03 09:17 PM