Thursday, August 18, 2011

Buffett on Borrowing Money: Berkshire Shareholder Letter Highlights

Warren Buffett wrote the following in the 2003 Berkshire Hathaway (BRKa) shareholder letter:

You may wonder why we borrow money while sitting on a mountain of cash. It's because of our "every tub on its own bottom" philosophy. We believe that any subsidiary lending money should pay an appropriate rate for the funds needed to carry its receivables and should not be subsidized by its parent. Otherwise, having a rich daddy can lead to sloppy decisions. Meanwhile, the cash we accumulate at Berkshire is destined for business acquisitions or for the purchase of securities that offer opportunities for significant profit.

The source of that cash pile is fueled, in part, by underwriting profits and float. Here's how he explains it in the 2010 Berkshire letter:

At Berkshire, we have now operated at an underwriting profit for eight consecutive years, our total underwriting gain for the period having been $17 billion. I believe it likely that we will continue to underwrite profitably in most – though certainly not all – future years. If we accomplish that, our float will be better than cost-free. We will benefit just as we would if some party deposited $66 billion with us, paid us a fee for holding its money and then let us invest its funds for our own benefit.

Well the underwriting profit streak, effectively Berkshire getting paid to borrow money, will probably end in 2011.

In this Bloomberg Businessweek article, Warren Buffett said that Japan's earthquake may lead to Berkshire's first underwriting loss for the first time in nine years.

Berkshire May Have Underwriting Loss

Berkshire generally has a mountain of cash and lots of new cash coming in each year via free cash flow from operations and new sources of float from the insurance businesses*. Yet, with all those sources of funds he still prefers that the subsidiaries do their own borrowing to impose discipline.

Berkshire may not be a bank but its $ 66 billion of float plays the same role as deposits at a bank. Somehow over the years Berkshire has figured out a way to, at least most of the time in recent years, consistently get paid for holding other peoples money while investing those funds for the benefit of shareholders. I wouldn't count on that continuing but the cost of float will likely remain cheap.

This model is the equivalent of a depositor receiving a negative interest rate then having the bank (Berkshire) generate something like a low teens percentage return with that money (or, in many instances when it comes to Buffett's skills, much higher).

The businesses that Berkshire has acquired will return 13% pre-tax on what we paid for them, maybe more. - Charlie Munger at the 2001 Wesco Financial Annual Shareholder Meeting

A well run bank is usually pretty satisfied with a 4% spread between what a bank pays depositors and what they can earn on the loans they make with the funds. Yet, at Berkshire, the spread can easily end up 2 to 3 times higher.

Borrowing money for close to nothing and earning say 12% to 14% with the investments you make is a pretty good business.

Even if the streak ends this year Berkshire will continue, in many years, to have a large source of funds that is sometimes cost-free. In the long run Berkshire's float will likely end up costing a few percent but that is still a large and stable source of cheap funds for the company.

Adam

Long position in BRKb

* Warren Buffett in the 2009 Berkshire Hathaway shareholder letterInsurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers' compensation accidents, payments can stretch over decades. This collect-now, pay-later model leaves us holding large sums – money we call "float" – that will eventually go to others. Meanwhile, we get to invest this float for Berkshire's benefit. Though individual policies and claims come and go, the amount of float we hold remains remarkably stable in relation to premium volume. Consequently, as our business grows, so does our float.

If premiums exceed the total of expenses and eventual losses, we register an underwriting profit that adds to the investment income produced from the float. This combination allows us to enjoy the use of free money – and, better yet, get paid for holding it.
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