To all those people trying to tell us how to invest our money, Warren Buffett’s secret to success at Berkshire Hathaway has always been simple. It’s to buy the right kind of stock and hold onto it forever. For those economists looking to understand this success, the puzzle typically goes much deeper than that.
No matter what, given that there are so many people looking to invest their money that there is definitely going to be one or more who have incredible success simply due to random chance makes this a certainty. But that is not a very satisfying reason at all to give for Warren Buffett’s consistent success over the last five decades. Economists would certainly like to be able to say something a lot more substantial than somebody’s got to be successful, so why not have it be Warren Buffett?
Pablo Triana, the Spanish professor, has a very interesting bit of insight as to what has been happening: Buffett has managed to set things up so that the funding costs of Berkshire Hathaway are well below the market. If you eliminate the factor of risk being taken, this has been negative many times. And if you have the ability to gain your finance at negative yield and invest those sums at a positive one, then there’s no question you’re going to do very well.
Triana specifically takes a look at the similarities between the large stock put options that Buffett has written as being against the rather small problems that engulfed the interest rate swap done by the Porto metro system:
“Yet it is auspicious that reports of this “scandal” have gained traction coincident with Berkshire Hathaway’s annual shareholders meeting. For Metro do Porto’s trade shares a lot in common with what Warren Buffett has so often done. In fact, the very secret sauce behind Buffett’s success lies in strategies that are at heart not too far from the swap that Santander engineered for its Portuguese client. The only main difference (a big one) may be the fact that while the Metro do Porto trade has been lambasted and eternally criticized, Buffett’s methods have received little but praise.
What is Buffett’s secret sauce? The so-called “float” generated through the sale of insurance policies and, in more recent times, derivatives. Berkshire collects upfront premiums from those sales, exposing itself to future potential losses from payments if the policies, or the derivatives, go against it. When the loss payments turn out to be lower than the collected premiums, Berkshire obtains positive float, in essence funding at a negative interest rate.”
This has been talked about before. As a company that provides insurance, and even more so as a reinsurance business, Berkshire Hathaway has an enormous amount of float that they hold. They can then invest this float into other investments and stocks. If you have the ability to finance your investing at zero financing costs, as Berkshire Hathaway does with the float, or even at rates that are negative, as they do with option premiums being received, then you can also do very well if you have investments that create a positive return. To a large extent this is the secret to Warren Buffett’s Berkshire Hathaway success.
There is a second point that also needs to be made: Buffett chose to invest in an insurance company to begin with. As pointed out by previous writers, this idea has given him incredible leverage to help build his personal and company fortune. There’s no question that Warren Buffett is one of the best investors of all time, and his stock picking and investment selection skills are amazing. But the reason he’s been able to make tens of billions of dollars rather than modest sums is that he took the skills and brought them into a much bigger investment pool that he had full control over by parlaying his personal fortune by becoming the owner of an insurance company. He owns an insurance company with large float, and it’s often below market and he sometimes even gets negative financing costs, and this means that he had two levels of leverage to achieve investment success.
Buffett success is not quite as simple as buying stocks and holding onto them, but he did it extremely well.