Do as Buffett Does Not as Buffett Says
When it comes to the use of leverage, Warren Buffett’s motto seems to be “do as I say not as I do.”
For decades, Buffett has spooled out folksy wisdom about the dangers of debt. But a recent paper from the quantitative hedge fund AQR reveals that Buffett has applied leverage at an estimated 1.6-to-1 ratio (a ratio comparable to private equity). AQR’s analysis shows that applying this amount of leverage to the market would have delivered average excess return of 10% per annum.
Buffett's performance has been extraordinary, but AQR proves that leverage has been a significant contributor to his success.
Figure 1: Buffett's Performance
Source: Frazzini, Kabiller and Pedersen (2013)
Buffett’s secret is the insurance float he manages for Berkshire Hathaway. “Collecting insurance premia up front and later paying a diversified set of claims is like taking a ‘loan,’” explain the AQR researchers. “Buffett’s low-cost insurance and reinsurance business have given him a significant advantage in terms of unique access to cheap, term leverage.”
Because he uses float, rather than say junk bonds, to leverage his portfolio, he can honestly say, “I’ve never borrowed a significant amount of money in my life. Never. Never will. I’ve got no interest in it,” and refer to “money that doesn’t belong to us but that we can invest for Berkshire’s benefit” growing from “$41 billion to $88 billion” in his most recent annual report.
Though not having to admit that you use leverage may be the best part of investing insurance float, a close second is that the cost of float is very low and sometimes, when there are underwriting profits, negative. As Buffett says, “we enjoy the use of free money —and, better yet, get paid for holding it.”
Figure 2: Buffett's Cost of Leverage: The Case of his Insurance Float
Source: Frazzini, Kabiller and Pedersen (2013)
Buffett claimed “in investing it is not necessary to do extraordinary things to get extraordinary results.” However, we find that Buffett in no way acted on his own advice. Indeed Oaktree's Howard Marks logically proved in a memo to his clients that one cannot expect unconventional (extraordinary) results from conventional (ordinary) behavior. Buffett separated himself from the pack not only by constraining himself to the value universe, but by applying a large amount of leverage at an unusually cheap rate.
Don’t be deceived by Buffett’s vague bromides about “wide moats” and “great franchises.” If you want to do as Buffett does, rather than as he says, look for people using leverage in smart and effective ways to amplify long-term returns. Think of the private equity pioneers who first thought to use leverage to juice the returns of small company investing. Think of Ray Dalio’s insight to use leverage on government bonds. Think of savvy insurers like White Mountain or Plymouth Rock. These great investors all developed structural investing advantages that didn’t rely on their own stock picking or forecasting abilities in order to succeed.