Insurance is a big reason why Berkshire Hathaway’s risk-adjusted investment return has been able to beat every mutual fund since the year 1976.
We learn this according to a new research paper from New York University and AQR Capital Management, told by The Economist.
The insurance and reinsurance companies that are part of Berkshire Hathaway lend money to the Berkshire Hathaway parent company, and they actually provide more than one third of the company funding. Buffett is then able to use this leverage as a way to purchase large quantities of stocks as an investment.
“This would be an expensive strategy if the [insurance] company undercharged for the risks it was taking,” states The Economist.
“But thanks to the probability of its insurance operations, Berkshire’s borrowing costs from this source have averaged 2.2%, more than three percentage points below the average short-term financing cost of the American government over the same period.
The insurance company also gives Warren Buffett a way to borrow money during both good times and bad times. “The long-term nature of the insurance funding has protected Mister Buffett during periods (such as the late 1990s) when Berkshire shares have underperformed the market,” states the magazine.
“Without leverage… Mister Buffett’s return would have been unspectacular,” says The Economist.
By having the insurance company leverage available to him, Warren Buffett is able to tap into this resource and by stock shares in high-quality companies that are struggling and going through hard times. He did this with Coca-Cola during the 1980s, and he was also able to gobble up shares of General Electric during the most recent financial crisis, we also learned from The Economist.
The magazine quotes Warren Buffett as saying, “It’s far better to buy a wonderful company had a fair price then a fair company at a wonderful price.”
Buffett has also “steered largely clear of more volatile sectors, such as technology, where he cannot be sure that a company has a suitable advantage,” notes The Economist.
All in all, not everything touched by Warren Buffett turns to gold. Berkshire Hathaway is the biggest shareholder of Moody’s rating company, and they lost roughly $340 million when the stock plummeted 22% last week.
This drop happened because the government is considering suing Standard & Poor’s, a rival of Moody’s, because of ratings practices that they implemented prior to the financial crisis taking place.