In business and investing, we employ capital to generate future cash flows. This capital comes at a price, which depends on its composition (debt or equity) and the perceived risk to the capital providers for investing in the opportunity. The value of a business is the sum of its future cash flows, discounted back today by its cost of capital. Thus business valuation is maximised when you structure this capital in such a way that it comes at the lowest possible cost.
One guy who has a pretty good track record of making money is Warren Buffett. While a lot has been written about how he does this and the kind of stocks that he likes to pick, a recent paper published by Andrea Frazzini, David Kabiller and Lasse H Pedersen puts the spotlight on how Buffett (and his investment vehicle Berkshire Hathaway) has been able to keep the costs of capital way lower than what others can achieve.
Buffett’s returns are the result of neither luck nor magic, but rather they are a reward for the use of leverage when investing in cheap, safe, quality stocks. It’s the leverage side that we’re interested in here because Buffett buys boring stocks that offer steady returns and then amplifies those returns by betting with borrowed money.
The sad news for any wannabe investment gurus out there is that this shows how it’s practically impossible for anyone else to make the same returns as Buffett, even if you chose the same shares to invest in. Let me explain what advantage Buffett has on the borrowing side.
The authors point out the main ways he generates an investing advantage:
- Buying low-risk, steady return businesses when they are undervalued
This has been covered extensively elsewhere and all that needs repeating here is that Buffett buys stocks when they are significantly undervalued, and holds them for a long time. He effectively makes the most of his return by underpaying for assets. This is no easy feat, but for the point of this article, it’s possible for you or me also to buy the same stocks at the same price.
- Large-scale debt
Buffett funds his increasing scale by issuing his own bonds. Needless to say this is not something you or I could do. Institutional investors buy Berkshire Hathaway’s debt, which is rated AAA – so he pays the lowest possible interest rates to the markets that he borrows from because he’s seen as so low risk. Taken to the extremes, he went as far as issuing a negative coupon security in 2002 (senior debt with a warrant).
- Insurance float
While many know that Buffett has always liked to invest in insurance businesses, it’s useful to think of why from a cash flow perspective: when you pay an insurance premium you are paying upfront for a potential payout later, if some insurable risk event takes place. From the insurer’s perspective, you get money today that you may need to pay back later. You can think of this as a loan against future claims. If you manage a diversified portfolio of risks, then what really happens is you are borrowing money. The authors of the paper work out that Buffett is paying only 2.2% to borrow money in this way – 3% cheaper than the rate which the US government borrows at when it issues treasury bills. This extra 3% offers a massive compounding advantage.
- Deferring tax through accelerated depreciation
Buffett finances the capital expenditure in his businesses by accelerating the depreciation. When you accelerate the depreciation of an asset, you pay less tax now but you will pay more tax in future. So you are deferring tax from now until later. But here’s the trick – the amount of tax you defer is constant i.e. it incurs no interest or compounding charges, so the longer you can defer it the less you actually pay. In Buffett’s case, what he’s effectively doing is taking an interest- free loan from the taxman. This is something we could all apply, depending on local legislation around accelerated depreciation.
The leverage which Buffett employs adds up and he employs leverage in a ratio of 1.6:1, i.e. for every $100 he invests, roughly 61% is debt and the balance equity. This is quite significant gearing, for most of us this level of debt would leave us horribly exposed to one or two margin calls.
The biggest lessons for me in Buffett’s strategy and achieved returns are not so much around his ability to pick stocks – the more important aspect is that he goes even further, doing everything he can to increase his returns by reducing his cost of capital along the way. He’s figured out how to reduce his cost of debt through issuing his own bonds, accelerating depreciation, and get massive working capital from insurance premiums. The effect is that he can lever more because his debt is cheaper.
So, for any given return, this is less capital at risk and all returns are amplified by the leverage he uses. As long as he keeps picking good, undervalued stocks it will be nearly impossible for anyone who is as good at stock-picking to catch up with the overall level of returns achieved.