Berkshire Hathaway Analysis

I remember asking a few fund managers when I was first studying Warren Buffett: do Berkshire's eye-popping returns (19.8% p.a. net of tax from 1965-2011: click here for the 2011 annual report) include or exclude the effect of leverage from the insurance business? Blank looks. I found this intriguing: seriously smart analytical types who are Buffett disciples not knowing a fairly basic question. Everyone in the stock market seems to be obsessed with gross returns. Tax doesn't get much of a mention, nor does the ability to finance the investment. Property investors on the other hand seem to have a much more holistic view: they consider tax issus such as depreciation and the impressive effects of leverage, assuming prices rise as all property investors do (need to...). It's always struck me there is a huge gap between stock market and property philosophy, and that property is in many ways more suited to the Buffett philosophy than stocks.

I stumbled on this research paper called Buffett's Alpha (click here for the article) breaking down the source of Berkshire's returns. It's extraordinary; the conclusion is that the primary source of alpha is the combination of leverage (an average of 1.6 to 1) and the very low cost of finance. Berkshire has enjoyed low finance costs thanks to superb management of the insurance business which has provided a very cheap float; sometimes the cost of float has been less than zero; meaning the interest rate has been negative. So while fund managers race around trying to find the next stock to invest in, are they not beter off finding low risk stocks, sprinkle a little leverage and just sit back and wait for growth to come through? I think so. And that's exactly what successful long term property investors do.

I've long suspected this to be the case, so I'm a little bit chuffed this research has been undertaken.

What are the implications? Well, not everyone likes leverage and most of us don't have access to ultra cheap, stable finance. However, implications are clear: when deciding between investments, also consider the possibility of leverage. An un-leveraged investment may not be appealing, but highly appealing if the price and income are stable and works well with leverage. I calculate IRR assuming no leverage and where possible/appropriate with leverage and I then weigh up the risks and decide which is the best investment. This forces a higher level of 'professionalism' on the process: instead of looking for the next best trade, consider the trades and strategy that will genuinely create long term wealth.