Warren Buffett is no doubt a savvy investor. But one secret to Berkshire Hathaway's (BRK.B) success is its leverage and its "less than free" funding source. In effect, it is a leveraged fund, except that it need not depend on margin or bank lending. BRK.B is mix of:
- A leveraged long only stock fund.
- A private equity fund
- A leveraged "macro hedge fund" trading in derivatives.
When everything is working perfectly, the results are outstanding. But the most recent financial results show some kinks in the armor. Those financial changes, in addition to the looming succession issue, may warrant some caution with regard to BRK.B. And if one looks at the message of the market in BRK.B's stock price, one can see those yellow caution flags quite clearly.
The Low-Cost, High-Test Gas That Fuels Berkshire
What is Buffett's secret fuel? It is Berkshire's insurance business that allows it to take in the insurance premiums and use them as funding for investments. The "float" he uses is composed of accumulated excess premium.
In his most recent letter to investors, Buffett notes:
Our insurance operations continued their delivery of costless capital that funds a myriad of other opportunities. This business produces "float" - money that doesn't belong to us, but that we get to invest for Berkshire's benefit.
As an excellent article in Bloomberg Businessweek explains:
Buffett, 81, entered insurance in 1967 with an $8.6 million acquisition. The expansion in float, together with Berkshire's earnings, gave the billionaire funding for his stock picks and acquisitions. The result has been comparable growth in Berkshire's stock price and float over a quarter-century.
Berkshire's success in attracting more insurance business each year than it loses has allowed Buffett to use policyholder funds to buy securities and keep them, in some instances, for decades. "Money we hold but don't own," as Buffett called float in 1997, has advanced in 27 of the last 28 years.
It seems like no one, including insurance regulators, has quarreled with his decades of success. Other insurance companies invest the premiums in fixed income, trying to simply generate steady cash flow with low risk (certainly lower risk than Buffett-type investments) along with a cash reserve to meet immediate claims. If they earn float at all, it is the minimal (and shrinking) spread between their free cash and the bond interest. Growth of the float, as we will see, is dependent in successful underwriting (avoiding large insurance losses) and growing the insurance business.
The High-Test Fuel and Buffett's Lower-Risk Stock Picking Strategy
Academic researchers Frazini and Pedersen have produced a fascinating paper demonstrating that across many asset classes, "betas don't line up." In other words, it is possible to purchase a portfolio of lower-beta (less risky) stocks that carry a higher risk/reward profile (higher sharpe ratio) than many higher-beta (riskier) stocks. Therefore, it would be possible to create a leveraged portfolio of low-beta stocks that would offer better risk/return characteristics than a market portfolio. That is true "alpha": better risk-adjusted returns, in other words.
Why does this "free lunch" persist instead of being arbitraged out as pure "efficient marketeers" would expect? The answer lies in the restriction against or reluctance of many investors, both institutional and individual, to invest with leverage.
The article includes a fascinating analysis of Buffett's public stock holdings. They find that Buffett owns a "low beta" portfolio, they calculate the beta at 0.8. That is not surprising, since he is a value investor. The researchers calculate Buffett's leverage based on debt as a percentage of book value, which has averaged 120%. Thus, they consider BRK.B to make use of 20% leverage.
In fact, taking into account the high-test fuel of premium float, the leverage is even higher. The net result is that Buffett effectively implements the leveraged low-beta strategy. So at least for the publicly held equities, Buffett uses over 20% leverage to purchase a portfolio with 0.8x the volatility of the overall stock market. Not only that, his funding through free float of premium is free or even at negative funding costs. The result: a lower-risk, higher-return portfolio -- found alpha -- when everything goes according to plan.
The Leveraged Private Equity Fund
Of course, many of Buffett's investments are in non-publicly traded companies, making Berkshire also partly a private equity fund. Here too the low-cost capital through the free float places Buffett at an advantage vs. other private equity funds with a higher cost of capital.
The Macro Hedge Fund
Buffett, at times, takes positions like a leveraged macro hedge or commodity trading advisor. Despite calling derivatives "weapons of mass destruction," he has entered into large derivative trades in the volatile currency market. He has held naked short positions in options, which risk unlimited losses in exchange for limited gains. This is one of the most risky derivative positions one could hold. It has limited upside and ulimited downside. Having worked in my previous life on the institutional side in currency options I can assure you of this. Every major "blow up" (massive losses) in the options markets is related to naked short option positions, whether simple or complex.
Unlike Buffett, most investors would run out of funding or have margin calls as the positions moved against them. They would not be able hold onto the positions, no matter how confident they were of their long-term market view. These positions would "blow up" and the trader holding the positions would face massive margin calls on the listed exchanges or calls for more capital or reduced credit lines in the over-the-counter derivatives market. The trader would be forced to get rid of the position, often just before the position would have turned into a profitable trade.
Buffett, with his massive capital base and huge credit lines with financial institutions, does not face these constraints. He can hold onto huge derivatives positions with mark-to-market losses without facing the conditions other "smaller" players (including huge hedge funds) would encounter. That could mean the position eventually does turn profitable or that the losses continue to build. In either case, the BRK.B investor gets the risky derivative positions as part of his investment along with the value oriented investments.
Some Caution Signs At BRK.B?
While it is certainly very premature to declare that the strategy is no longer viable in the long term, the recently reported earnings report shows some kinks in the armor. In fact, it shows a bit of a negative perfect storm:
1. The Free Money Machine is Running Low On Fuel
The pool of costless capital that drives Buffett's investments is unlikely to grow much in the future. The Buffett annual letter to investors sets out the reasons.
- Underwriting losses on the insurance business. These obviously cut into the pool of money that can be used to fund investments. Losses totaled $581 million last year.
- Increased long term competition in the insurance business hence less inflows of premium.
- As a consequence float grew but at a much slower pace than the past. Here are the float numbers from Buffett's annual letter:
Year Float (in $ millions)
- 1970 $ 39
- 1980 237
- 1990 1,632
- 2000 27,871
- 2010 65,832
- 2011 70,571
As to the future, the letter notes:
It's unlikely that our float will grow much - if at all - from its current level. That's mainly because we already have an outsized amount relative to our premium volume. Were there to be a decline in float, I will add, it would almost certainly be very gradual and therefore impose no unusual demand for funds on us.
2. Massive Mark to Market Losses in Risky Derivatives.
Buffett is rightly known as a cautious long term value investor in publicly traded equities and purchaser of private companies. But he hasn't shied away from taking some extremely large positions in what he calls "weapons of mass destruction," i.e., derivatives. And he has mark to market losses of a magnitude that would shut down many hedge funds through a combination of margin calls at investor withdrawals.
Berkshire's latest financials report massive mark to market losses on derivatives. The magnitude of the swings in value give an indication of just how large, risky and volatile the trades are. The positions declined in value from $1.4 billion to $382 million in one year!
The track record of the Oracle of Omaha obviously gives investors confidence in his views and more patience with regards to these positions. In the case of many individuals, they may not understand the risks involved. But I am not so sure that confidence should extend to these derivatives trades. Anyone who purchases or owns BRK.B stock is effectively making a bet that these derivative trades with large losses will turn profitable.
All this added up to a decline in income for the fourth quarter of 30% $1.84 per share vs.$2.65 a year ago. The loss exceeded analysts expectations.
Book Value and Market Value: Mr. Buffett vs. Mr. Market
Buffett measures his investment success in a rather unique way. He calculates BRK.B's book value based on his assessment of what the various holdings are worth and measures that performance vs. the S&P 500. Remember that book value includes valuations of many private corporations for which there is virtually no way for an outside party to verify valuation.
Of course, that book value is not the cash price at which BRK.B stock is bought or sold. So from the point of view of a real world investor, it has limited relevance.
Here is the real world gap between Mr. Buffett and Mr. Market's valuations:
For 2011 Buffett calculates that BRK.B returned investors 4.6% vs. 2.1% for an S&P 500 investor's total return including dividend an "outperformance" he delivered to investors of 2.5%.
But in the marketplace of real money investing an investor that bought BRK.B at the end of 2010 and sold it at the end of 2011 would have lost 4.8% in price and collected no dividends. That is an underperformance of 6.9% in realizable performance vs. the S&P 500 total return.
Book Value Market Value and Succession at BRK.B
Berkshire is trading at a historically low price to book value. The long term average is 1.6, it is currently trading at 1.16x book lower than the level immediately after the 1987 crash. Most analysts attribute this to uncertainty over succession. Buffett has expressed confidence of BRK.B's success after his departure. Apparently investors are not so sure.
Here's a chart from from website market playground:
In the investor letter Buffett explains their attitude towards book value and stock buybacks as follows:
Charlie and I have mixed emotions when Berkshire shares sell well below intrinsic value. We like making money for continuing shareholders, and there is no surer way to do that than by buying an asset - our own stock - that we know to be worth at least x for less than that - for .9x, .8x or even lower. (As one of our directors says, it's like shooting fish in a barrel, after the barrel has been drained and the fish have quit flopping.)
Nevertheless, we don't enjoy cashing out partners at a discount, even though our doing so may give the selling shareholders a slightly higher price than they would receive if our bid was absent. When we are buying, therefore, we want those exiting partners to be fully informed about the value of the assets they are selling. At our limit price of 110% of book value, repurchases clearly increase Berkshire's per-share intrinsic value. And the more and the cheaper we buy, the greater the gain for continuing shareholders.
Therefore, if given the opportunity, we will likely repurchase stock aggressively at our price limit or lower. You should know, however, that we have no interest in supporting the stock and that our bids will fade in particularly weak markets. Nor will we buy shares if our cash-equivalent holdings are below $20 billion. At Berkshire, financial strength that is unquestionable takes precedence over all else
If I am parsing the above correctly, I would conclude as follows: We think our stock is a bargain below book value, we would buy up to 110% of book, but if the other bids are weak we won't support the stock, and we won't let stock buybacks eat too much into our cash position. I would actually put it more simply: "Don't count on stock buybacks to bail you out if the stock prices falls relative to book."
Looking at the historically low price to book ratio, some might see BRK.B as a bargain. In light of the succession issues, the derivative positions and the end of the large glide path for growth in free float others might see this as a time to avoid or even sell BRK.B stock.
That decline in the book value has been a major reason why BRK.B has significantly underperformed the S&P 500 for the past 2 years. In order to make a bullish case for BRK.B going forward, one would need a significant increase in book value and the price/book ratio of Berkshire just as all the above mentioned negatives are becoming more salient.
That might make it a tough battle for BRK.B's future stock chart vs the S&P 500 to look much different than this one: