Secret Revealed: Warren Buffett is not a Stock Market Superstar
Sowmay
A Big Myth – Warren Buffett is rich (successful) because he is indulged in stock market.
No doubt WB (his company) invest in stock market but the main revenue pillar of the company is something different.
First of all, Warren Buffett’s personal investment is almost nil in stock market. He is rich because of the high valuation of his company – “Berkshire Hathaway”. He retains a high amount of stake in the company which is over 99% of his personal wealth.
This is what he said in Annual letter year ended 2001 (Page – 3):
Image read – I will keep well over 99% of my net worth in Berkshire. My wife and I have never sold a share nor do we intend to.
And instead of stock market, BH is highly engaged in “Merger & Acquisition” (later is more). And the main operation is “Insurance”.
WB examined the point in his own sarcastic tone (AL 2001, page -6):
Image read – Our main business – though we have others of great importance – is insurance.
Stock market (Investments) can be ranked 3rd after above two.
That is why main revenue source of the company is not stock market and Warren’s +99% of wealth is in the BH – hence – Warren Buffett is not rich (successful) because he is indulged in stock market.
I had read many Annual letters of Warren Buffett and found that at very few places he talk about stock market as compared to above 2 bold components.
Now, to explain you the whole business model of Berkshire Hathaway – I divided the answer into 4 sections:
In this article, I’m going to explore following things:
I hadn’t read any annual letters of BH before Financial year ended 2000 as they were written as per the then economy of America so hard to digest.
However, I had read many of the 21st-century letters. FYE 2001 (9/11 case), 2008 (financial crisis) and 2015 (recent letter) are my favorite one.
Hey, Hold on! I found that many of you don’t understand the abbreviations used in the answer. Below is the key:
WB – Warren Buffett.
BH – Berkshire Hathaway.
M&A – Merger and Acquisitions.
FYE – Financial Year Ended.
AL – Annual Letter.
Let’s discuss the first section – Float (Insurance): Warren’s Strategy.
I found one thing common in all of the letters – Generally, they were divided into 3 sections in the following sequence:
Insurance.
Acquisitions.
Investments.
Berkshire Hathaway primary source of funds for Acquisition and Investments are the floats generated by its Insurance branch.
What the heck is this – “Float”?
To start with, float is the money we hold but don’t own.
Pay attention, keenly read this part. This can form a good base for shaping your investment decisions.
A quick question – How does company fetch capital for financing their business?
Simple.
Equity – funds endorsed by shareholders.
Debt – funds in exchange of interest charge.
There is also an another form of source to finance the business – “FLOAT”
For raising equity – management, control, dividends, ownership etc get dissolved and for debt, you need to pay interest but for float – you pay nothing (in any form).
In case of Insurance, we can say – Float is the amount of money on hand at any given moment that an insurer has collected in insurance premiums but has not paid out in claims.
It can also be in others forms like:
Advance from suppliers.
Deferred taxes.
Advance from customers.
Sustained deposits.
Motive is just to retain cash with the company for free. People pay premium and receive claims but an exact/increasing amount of cash remain forever with the company.
Insurers start investing insurance premiums as soon as they are collected and continue to earn interest or other income on them until claims are paid out.
That’s the concept used by Warren Buffett.
Here’s the shock:
What if I say you that I’ll pay you for keeping my funds with you (no restrictions). Heck! Something bad happened to me, right?
That’s what people do with BH.
They pay it for keeping their funds with no restrictions.
Here is what Warren Buffett stated in Annual Letter FYE 2001 (page – 6):
Image read – Historically, Berkshire has obtained its float at a very low cost. Indeed, our cost has been less than zero in about half of the years in which weíve operated; that is, weíve actually been paid for holding other peopleís money.
Later, in the letter, he also showed up the floats collected throughout the period.
Isn’t it dazzling?
Here’s Buffett on the float (in AL FYE 2009):
Insurers receive premiums upfront and pay claims later. … This collect-now, pay-later model leaves us holding large sums — money we call “float” — that will eventually go to others. Meanwhile, we get to invest this float for Berkshire’s benefit. …
If premiums exceed the total of expenses and eventual losses, we register an underwriting profit that adds to the investment income produced from the float. This combination allows us to enjoy the use of free money — and, better yet, get paid for holding it. Alas, the hope of this happy result attracts intense competition, so vigorous in most years as to cause the P/C industry as a whole to operate at a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. Usually this cost is fairly low, but in some catastrophe-ridden years the cost from underwriting losses more than eats up the income derived from use of float. …
Our float has grown from $16 million in 1967, when we entered the business, to $62 billion at the end of 2009. Moreover, we have now operated at an underwriting profit for seven consecutive years. I believe it likely that we will continue to underwrite profitably in most — though certainly not all — future years. If we do so, our float will be cost-free, much as if someone deposited $62 billion with us that we could invest for our own benefit without the payment of interest.
Let me emphasize again that cost-free float is not a result to be expected for the P/C industry as a whole: In most years, premiums have been inadequate to cover claims plus expenses. Consequently, the industry’s overall return on tangible equity has for many decades fallen far short of that achieved by the S&P 500. Outstanding economics exist at Berkshire only because we have some outstanding managers running some unusual businesses.
So find these types of companies in stock market, Most possibly high float driven companies are moat companies.
Let me give you an example of a Company with high floats – AMAZON.
Amazon is an excellent example of a Float & Moat company:
Keenly, observe the balance sheet of Amazon. I’ll wait.
The breakup of Asset side is as under:
Financial Assets (Cash and cash equivalents and marketable securities): $19.7 billion.
Amazon enjoys a float of $44.4 billion even though it employs only $45.7 billion of operating assets! Almost all of the operating assets are financed by floats.
But, how does it get so much float?
Account payable contributes the highest floats (aka advanced from the vendors) – 30.7 bn.
It has a negative working capital.
By keeping inventories low, by ensuring customers pay Amazon quickly, and by taking longer to pay its vendors, It has been able to build a huge float.
I’m also an associate partner of Amazon. I get commission for every product I promote. They pay us 60 days after we actually entitle to receive the commission. Here, they manage to get 60 days float of the commission due to all of its partner associates which they can use in whatever way they want.
In addition, the successful Amazon Prime service and sale of gift certificates enables the world’s largest online retailer to collect funds from customers in advance.
Related: Fundoo Investor had explained the concept of “Float and Moat” deeply in a presentation here. Consider reading the presentation.
Strategy for Stock Market: Hunt for float companies. They outperform in long run. They have enormous cash and free funds that they can deploy in their business operations with less or no extra cost.
Now let’s switch to 2nd section – Why M&A?
Before I met, of course digitally, a well-experienced person – Mr. Currier who lives in Boston, US, I think WB as a stock market superstar.
A quick intro: Mr. Currier is indulged in the business of connecting 2 companies (Target and buyer company) for M&A deals. He also took part in some deals with Warren Buffett.
After having a quick conversation with him, I understood that Warren Buffett mainly a superstar in Acquisition instead of stock market.
With huge funds, acquisition is far much better than investing in stock market. Acquiring other companies give multifold benefits. Additionally, it helps to reduce operating costs (if the acquisition is done in any related/subsidiary field) – Like Pepsi bought Stacy’s Pita Chip Company.
That’s what Warren do with its floats funds – Acquisitions.
At initial years, when the availability of cash was low, WB was indulged in Merging Buz but now, with huge incoming cash, he do Acquiring.
WB had created a big spider web with each thread contributing the prime company in consideration of doing nothing.
There are 2 types of Acquisition:
Acquisition.
Bolt-on Acquisition.
Former simply means – company buying the whole another company and later means – acquisition of a company by any subsidiaries of prime company (indirectly adding wealth to the prime company).
For example: Imagine for a sec – BH bought company A and company A buys company B. Former is simple acquisition and later is bolt on acquisition.
So BH gets benefitted in a double way – many subsidiaries of the prime company (BH) also takes part in M&A activities. That mean no additional work for them, yet more earnings for Berkshire, a combination that they find highly appealing.
Have a look (AL – FYE 2015, Page – 5):
Apart from these bolt-on acquisitions: The prime company keep acquiring companies by the free cash they receive from their existing subsidiaries, bolt-on subsidiaries, stock dividends, capital gains and finally, Insurance floats.
All these will keep increasing with the expansion of the prime business which Indicates a bright future.
This is how Warren Buffett constructed his business model which will sustain for a long even if he doesn’t work. Though there are many others to work.
BH have dozens of insurance subsidiaries and more than 80 non-insurance subsidiaries & bolt-on acquisitions are increasing at a great pace. Multifold effect.
Additionally, all the acquisitions are made in “Cash” to maintain the ownership of the existing shareholders.
Following is the words stated by Warren Buffett in company’s Annual letters FYE 2001 (Pg – 4) :-
Image read – Additionally, all of our purchases last year were for cash, which means our shareholders became owners of these additional businesses without relinquishing any interest in the fine companies they already owned. We will continue to follow our familiar formula, striving to increase the value of the excellent businesses we have, adding new businesses of similar quality, and issuing shares only grudgingly.
That is why, one should always keep seeking for Cash Rich companies. They have the power to buy precious things without raising funds.
That’s enough of M&A, let’s switch to 3rd section.
Warren Buffett and Stock Market.
Here comes the controversial part.
We all think Warren Buffett as a good stock market Investor and he is rich/successful because he invests in stock market.
That’s A BIG MYTH.
No, I’m not saying that he is not a good stock market investor. Indeed, he is excellent.
What I want to say is that he is rich/successful not because he invest in stock market, instead he is good at operating his main business “Insurance” and finding out good companies at cheap rates & acquiring it as a whole, which is not possible in stock market (can’t purchase a whole company).
Additionally, Warren Buffett once, in his recent AL 2015, explained the simple blueprint for how they build up BH’s strong intrinsic value:
Image Read as follows:
Considering this favorable tailwind, Berkshire (and, to be sure, a great many other businesses) will almost certainly prosper. The managers who succeed Charlie and me will build Berkshire’s per-share intrinsic value by following our simple blueprint of:
Constantly improving the basic earning power of our many subsidiaries;
Further increasing their earnings through bolt-on acquisitions;
Benefiting from the growth of our investees;
Repurchasing Berkshire shares when they are available at a meaningful discount from intrinsic value;
Making an occasional large acquisition.
Management will also try to maximize results for you by rarely, if ever, issuing Berkshire shares.
Aggregately, he talked about 3 main pillars:
Acquisitions.
Bolt-on Acquisitions.
Buy Back of Shares.
Not a dim of Stock Market.
Am I the only one who noticed that the above blueprint didn’t give even a single shit to “Stock Market”?
Above first 2 sections are enough to understand the point that how excellently WB maintained his company’s Insurance and Acquisition branch. However, as usual, he always talks about the stock investments in his annual letters like:
You’ve already heard about some of his great picks – Amex, Coke, Wells Fargo, Walmart etc. You can see the difference between cost and market column above. Excellent capital gains.
Here’s a shock:
Most of the news which gets aired in on the web about Warren bought this company or that company are all flawed.
Yes! All the big news players are wrong.
“Hey! Sowmay, Are you gone mad? How can whole big news machines can go wrong? People trust them” – you might say.
Don’t believe me. Do you believe Warren Buffett?
Warren Buffett a very shocking thing in one of his AL.
Source – AL FYE – 2001 (page – 16).
Image read – One more point about our investments: The media often report that “Buffett is buying” this or that security, having picked up the ìfactî from reports that Berkshire files. These accounts are sometimes correct, but at other times the transactions Berkshire reports are actually being made by Lou Simpson, who runs a $2 billion portfolio for GEICO that is quite independent of me. Normally, Lou does not tell me what he is buying or selling, and I learn of his activities only when I look at a GEICO portfolio summary that I receive a few days after the end of each month. Louís thinking, of course, is quite similar to mine, but we usually end up in different securities. Thatís largely because heís working with less money and can, therefore, invest in smaller companies than I. Oh, yes, thereís also another minor difference between us: In recent years, Louís performance has been far better than mine.
Instead of stock market, Warren Buffett is more or less indulged in acquisition business. His manager takes care of its stock market operations. Yet, sometimes WB himself invests in stock market.
Apart from delivery trades, BH also has their hands in derivative market (F&O).
Yes! the Warren Buffett also participate in derivative tradings (only options, not futures). This is the same Warren Buffett who stated “Derivative as dangerous”:
Now a question might bubbling in your mind – Why in the world, WB indulge in risky derivative instruments?
Just for – FLOAT.
Yes! it’s another source of float for BH.
Really, WB is a genius. His mind is far beyond than average person like you and me.
Let me explain you – how he uses option instruments to generate floats.
First of all, he doesn’t operate 1 to 3 months options deals like we do in our Indian stock market.
As per my awareness, WB signs only direct option deals which last for years i.e. 10, 15 or even 20 years. And all of us know Warren always stay on the positive side in long run – hence he never loses on long run derivative tradings.
This is how Warren Buffett generates Floats through Options:
Our derivatives dealings require our counterparties to make payments to us when contracts are initiated.
Berkshire therefore always holds the money, which leaves us assuming no meaningful counterparty risk.
As of yearend, the payments made to us less losses we have paid – our derivatives “float,” so to speak – totaled $8.1 billion.
This float is similar to insurance float: If we break even on an underlying transaction, we will have enjoyed the use of free money for a long time.
Our expectation, though it is far from a sure thing, is that we will do better than break even and that the substantial investment income we earn on the funds will be frosting on the cake
The above-quoted text is from his FYE 2008 Annual letter (page – 18):
The company is indulged in 4 categories of option instruments for which you get information in the above stated AL, same page.
So this is how Warren is indulged in stock market in 2 ways, stock ownership, and derivative instruments. Yet, more emphasis is on Insurance and Acquisition branch (as already explained above).
Enough of this walk, let’s talk about next station.
I assume, now it’s easy to digest the fact that Mr. Buffett is not successful because he invests in stock market.
Though, like other money managers, he is an excellent stock picker. He had made many good investments in his early days and still hold them. Amex, Coke, Fargo are few of them.
Let me cut the crap and directly hit the nail.
What made you think that – the current market scenario when stock prices are at its peak?
There is a reason why the stock prices at their peak (actually, they are not). In stock market, nothing happens for without a reason.
Indian economy is growing at a good pace and its future estimation is also quite clear. This leads a certain climate which boosts the confidence of people in market and that is why – they feel safe to invest in stock market leading to sustainable prices.
Okay, let’s assume that the prices are their peak but still…..
Opportunities are always available in market, even when the market is highly bullish or highly bearish.
It’s on you how much of that you can find.
Even at the times of financial crisis (2008), many stocks remain unaffected, same thing happened at Brexit event.
Now even at the peak time, many stocks still remain unaffected. I’ve some stocks in my watchlist which had not move the needle in either direction since when I was tracking them. Though they are good with excellent a/c books.
Agreed – that the number of opportunities will be less in bullish trends as compared to bearish trend but it doesn’t deny the fact – Opportunities are always there in market.
It depends on you – how much and how fast you find them.
Most probably, the company with excellent fundamentals and less or no market traction remain hidden gems even at peak times.
Remember, the stocks which fluctuate the most in market are the one which are under analyst coverage (market traction).
Exchanges comprise of more than 7k listed stocks. Many of them are not traded at all. Many are just traded a bit.
70% of the total trades occurs in large caps.
Why?
Because they are under analyst’s coverage. People consistently receives news, shots, happenings of this stock as compared to other not known stocks.
Now, What will WB will do if the markets are at their peaks?
As I said, WB is much indulged in acquiring non-listed companies (where price didn’t fluctuate on daily basis) so there will be “no case” for what he will do?
He will always a market where he can deploy his funds in much better use. He will simply stay away from stock market and wait for an opportunity that is much better than his company usual operations.
Remember, Warren’s most of the best picks in stock market were in 2008 financial crisis (when the market crashed to a great extent).
And there were also times when WB and his partner Charlie had not pulled the trigger for years. They just wait for opportunities to knock their door.
Images in the answer are from the following BH Annual letters FYE 2001, 2008, 2009 & 2015 (download links).
[su_box title=”Quick Announcement” box_color=”#f5d552″]Do you want all letter at one place? Get all the BH Annual Letters (1965-2012) in just one PDF file (4.5 Mb) – Click the following image to download the file.[/su_box]