Memo #6: Farewell, Warren

Also: Ferrari goes Vroom Vroom

Had to shed a tear or two at Buffett’s announcement of his retirement at Berkshire’s ASM in the weekend. Retiring at the ripe young age of 94 (just a spring chicken!)

Lots has been written about him in the past few days — I won’t bore you with going on too much. Not as much has been made of one of his key advantages that would be the envy of any fund manager — his insurance float. This float (via National Indemnity, General Re, GEICO etc) is the difference between premiums collected and claims paid out. Now, usually an insurance company will have the ‘float’ invested in a bunch of low-risk investments, like short term bonds and so on. Buffett, on the other hand, uses float like an interest free loan — i.e. it is a form of leverage to earn returns on equities, paid for by those who pay insurance premiums.

Lou Simpson managed GEICO’s investment portfolio until his retirement in 2010. His track record speaks for itself:

Currently Berkshire has a float of ~$173 billion, which gives it a $173 billion dollar advantage. That’s significant! Here’s the man himself on float¹:

Since 1967, when we entered the insurance business, our float has grown at an annual compounded rate of 20.7%. In more years than not, our cost of funds has been less than nothing. This access to "free" money has boosted Berkshire's performance in a major way. Any company's level of profitability is determined by three items: (1) what its assets earn; (2) what its liabilities cost; and (3) its utilization of "leverage" that is, the degree to which its assets are funded by liabilities rather than by equity. Over the years, we have done well on Point 1, having produced high returns on our assets. But we have also benefitted greatly to a degree that is not generally well-understood because our liabilities have cost us very little.

An important reason for this low cost is that we have obtained float on very advantageous terms. The same cannot be said by many other property and casualty insurers, who may generate plenty of float, but at a cost that exceeds what the funds are worth to them. In those circumstances, leverage becomes a disadvantage. Since our float has cost us virtually nothing over the years, it has in effect served as equity.

Now that’s some secret sauce!