How Warren Buffett Achieved Such Phenomenal Success with Berkshire Hathaway
How Warren Buffett Achieved Such Phenomenal Success with Berkshire Hathaway
Just How Successful has Warren Buffett been with Berkshire Hathaway?
It’s difficult to grasp the sheer magnitude of Warren Buffett’s success in growing the value of Berkshire Hathaway. The returns, on a per share basis, over the last 50 years, have compounded up to numbers that are so far outside the normal range of experience and expectation as to almost defy comprehension.
In his 50 years of controlling Berkshire Hathaway, Warren Buffett has increased its book value per share from $19.46 to $144,565 as of September 30, 2014. This is an absolutely staggering gain of 742,783%. Amazingly, this represents a compounded return of “only” about 19.5% per year. This is probably the best result world-wide over 50 years for any company that started out with any significant assets. Berkshire was already a fairly large company when Buffett took over. At the start of fiscal 1965 it had book equity of $22 million and had 2,300 employees.
Berkshire’s market price per share has risen even faster than its book value and has risen over one million percent in these 50 years. A $1000 investment in early 1965 would be worth over $15 million today.
Return on Equity and the impact of retaining all earnings instead of paying out a portion of earnings as a dividend each year
Berkshire’s annual return on equity (counting after-tax realised capital gains as earnings) has also averaged approximately 19.5% over these 50 years. This is the case for Berkshire because there were no dividends (save, ironically enough, one thin dime per share paid out in 1967) and because there was only a minor issuance of shares (in association with certain merger and purchase transactions), and those issuances were not at very high multiples of book value.
It’s one thing for a company to earn an ROE of almost 20% in any given year. It’s another thing for a company to manage to earn an average ROE of almost 20% for 50 years or even for several decades. But it’s unique and stunning for Berkshire to have compounded its equity per share at almost 20% for 50 years.
Most companies that earn double digit ROEs dividend out a large part of their earnings annually or use the earnings to buy back their own stock. If they were to retain all of these earnings they would quickly run out of lucrative double digit ROE projects to invest the retained earnings in and their ROE would quickly decline.
If a company matched Berkshire’s 19.5% ROE for 50 years but paid out half the earnings as a dividend and if the investor could only earn 10% by reinvesting the dividends received in other stocks, that investor would have compounded her money at “only” 13.6%. In that case the investment would have grown by 59,608% in 50 years. That would be phenomenal, but still far short of Berkshire’s book value per share gain of 742,783%. And the company itself would have grown its book value per share by “only” 10,377%
Even if Berkshire had paid a dividend of just 30% of earnings each year, and if investors had earned an average of 10% when they reinvested their dividends on their own, their gain would have been 137,365%. Again, phenomenal but far short of 742,783%. And Berkshire’s book value per share would have increased by “only” 59,944%.
If all of Berkshire’s earnings had been paid out as dividends each year and if the investors earned an average of 10% by reinvesting those dividends elsewhere then those investors would have seen gains of 22,696% in 50 years. In this case Berkshire’s wonderful 19.5% ROE would have remained applicable only to its original 1965 equity level of $19.46 per share.
Buffett’s success with Berkshire was achieved in part by earning (counting after-tax realised capital gains) an average of almost 20% on equity for 50 years. But the real key was the fact that all earnings were retained and that Buffett somehow found ways to earn that average 19.5% ROE despite the fact that the capital with which he was working was growing at an average of 19.5% annually which is nothing short of explosive exponential growth. The retaining of all earnings combined with the 19.5% ROE allowed the original capital per share to continue to compound at an average of 19.5% for 50 years. It seems likely, that no other company that started with over $20 million in equity has ever managed to compound that equity on a per share basis at 19.5% for 50 years.
Berkshire’s high ROE was not primarily due to leverage.
One way to generate an ROE of 20% would be with massive leverage. With financial leverage the assets become significantly larger than the equity. Banks, for example, typically leverage their equity at least 10 times. Before the 2008 financial crisis many large banks were leveraged about 20 times. With 20 times leverage a 1% return on assets translates into a 20% ROE.
Some sources have attributed Berkshire’s success to leverage. But the facts say otherwise.
One academic paper claimed that leverage was a major contributor to Berkshire’s success. But then it noted that the leverage had averaged 1.6 to 1. The problem with that claim is that 1.6 to 1 is not a high leverage level for a typical operating business. It implies equity of 62.5% of assets which would not be high leverage for most companies and is in fact unusually low leverage for a publicly traded company heavily involved in the insurance business. Allstate, for example, had shareholder equity of just 17% of assets at the end of 2013. That is leverage of 5.9 to 1. In Canada, one of the largest property insurance companies is Intact Financial and it had equity of just 25% of assets at the end of 2013, resulting in leverage of 4.0 to 1. The academics attempt to explain Buffett’s success in comparison to un-leveraged stock funds. But they don’t compare his returns with Berkshire to other corporations. They also do not address the income tax disadvantage that Buffett faced when investing in stocks through a corporation rather than through a partnership or mutual fund.
Berkshire does leverage its equity. But it has used far less leverage than most publicly traded insurance companies and its leverage is not high even compared to most non-financial companies.
Suggestions that Buffett’s success with Berkshire has been due to an unusually high level of leverage simply do not stand up to scrutiny.
Berkshire’s high ROE was boosted by its unusually low cost for the modest leverage that it did employ.
The normal way to achieve leverage is through debt. But debt costs money for interest payments. For much of the time that Buffett has controlled Berkshire, interest rates on even high quality corporate debt were high. If Berkshire had used long-term debt for leverage it would have had to pay interest rates of 8% or even well into double digits in many years.
However, as demonstrated below, Berkshire used little or no debt in its insurance and investing operation. (It did use debt in its small lending operation and in recent years in its utility and railroad businesses.) Berkshire’s two main sources of financial leverage were insurance “float” and deferred income taxes.
Insurance “float” was a large and low-cost form of leverage for Berkshire over most of the last 50 years. Float represents money ear-marked for future insurance claim payments that meanwhile can be invested. In 2013, for example, Berkshire made an underwriting profit on insurance that amounted to 4% of its float. This meant that the float, in 2013, was effectively a form of leverage with a cost equivalent to a negative 4% interest rate. Most insurance companies face a positive cost of float. Berkshire has had a negative “cost” of float in more years than not.
In addition, Berkshire used deferred income taxes as an interest-free form of leveraging. Berkshire had an unusually large amount of deferred income taxes over much of the past 50 years. This was due in large part to the fact that it maintained large unrealized gain positions in many stocks.
The lower-than-debt cost of leverage provided by float and deferred income taxes boosted Berkshire’s ROE by an average of perhaps 2% per year. That may not seem like a lot but consider that money compounding at 19.5% for 50 years grows to an amount that is more than double the amount that money compounding at 17.5% grows to – 133% higher to be precise. Such is the power of compounding. A little higher rate of compounding goes a very long way when you talking about 50 years.
Berkshire achieved a high return on assets
In the absence of high leverage, the way to achieve a high return on equity is to achieve a high return on assets. It is therefore clear that Buffett and Berkshire Hathaway achieved a relatively high return on assets compared to most companies and that its return on assets was far higher than that of most insurance companies (which had far lower ROEs despite the use of high leverage).
The nature of Berkshire’s activities and assets and how they were funded
Berkshire’s core activity since shortly after Buffett took control in 1965 has been to operate a property and casualty insurance operation which invests in stocks, bonds and non-insurance subsidiary businesses with these assets and investments funded by, in order of importance, common equity, insurance float, accounts payable and other including deferred taxes, and a very modest amount of debt.
This operation differed from most other insurance companies in at least three major ways:
- Financial leverage (including debt and insurance float) was and is unusually low and the common equity ratio unusually high.
- Investments were and are concentrated in equities and even the ownership of entire businesses rather than in bonds.
- The insurance operation was and is unusually profitable (or had unusually small losses) even before considering profits from investments.
To illustrate, here is a simplified view of Berkshire Hathaway’s Insurance and investment assets, on a percentage basis and how they were financed as at the end of 2013. This excludes the railroad and utilities segments as well as the finance segment. Those two excluded segments do use a lot of debt leverage. The rail and utility sectors are more recent additions to Berkshire and are excluded because they do not reflect its core insurance and investing operation. The finance sector is excluded because it also does not reflect the core operation and is, in any case, quite small.
|Berkshire Hathaway Insurance and Other Segment — Year End 2013|
|Assets||Liabilities and Owners Equity|
|Cash and cash equivalents||14%||Insurance liabilities(float)||28%|
|Investments – fixed maturity||9%||Accounts Payable and other||7%|
|Investments – equities and other||45%||Debt||4%|
|Business assets including goodwill||33%||Owner’s Equity||61%|
Some notable characteristics of this condensed balance sheet include:
- A very high level of equity (which is composed largely of retained earnings)
- Very little debt
- A significant but not over-whelming level of insurance float liabilities
- The famously high allocation to cash
- Only a modest level of investments in fixed maturity investments(bonds).
- A very high level of investments in equities
- Substantial investments in subsidiary non-insurance operating businesses including purchased goodwill of these businesses and of the insurance businesses.
The oldest balance sheet that I have available is from 1995. The following is the full consolidated balance sheet from the end of 1995 on a percentage basis:
|Berkshire Hathaway for the Year End 1995|
|Assets||Liabilities and Owners Equity|
|Cash and cash equivalents||9%||Insurance liabilities(float)||14%|
|Investments – fixed maturity||5%||Accounts Payable and other||4%|
|Investments – equities and other||73%||Finance business debt||2%|
|Finance Assets||3%||Other Debt||4%|
|Business assets including goodwill||9%||Deffered Income Tax||17%|
Back in 1995, the liability side of the balance sheet was supported 59% by equity, similar to 2013. Insurance float was a smaller percentage of the liabilities and deferred taxes supported 17% of the assets. Debt was very low, similar to 2013. On the asset side of the balance sheet, there was a significant allocation to cash. The allocation to fixed maturity investments (bonds) was quite low. Almost three quarters of the assets were invested in equities. (In part this is because the equities were marked to market while business assets were not.) The percentage of assets devoted to subsidiary businesses and goodwill were much lower than in 2013.
Keys to Warren Buffett’s Success:
The material above documented the level of success achieved and has demonstrated that it was achieved by earning unusually high returns on assets accompanied by some use of unusually low-cost insurance float and zero-cost deferred tax leverage and by a very modest amount of debt leverage. The sections below provide a number of factors which further explain Buffett’s extraordinary success with Berkshire Hathaway.
Setting a growth per share goal and sticking to it
From the start, Buffett’s goal was to grow the per share value of Berkshire Hathaway at a rate well above the average annual returns of the S&P 500. As an approximate but imperfect measure of this he used the growth in Berkshire’s book value per share. He has never wavered from this goal and this measuring stick.
Retaining all earnings
As documented above, Berkshire’s phenomenal growth in value per share would have been severely reduced if it had paid out even a modest dividend over the years. By retaining all earnings and by continuing to find investments that would earn an average of almost 20% per year, Buffett accomplished the compounding of his starting book value per share at almost 20% per year as of 2014. If all of the earnings were not retained then the original book value per share would not have compounded at anything close to 20% even with the near 20% average ROE achieved at Berkshire.
A high level of equity and low debt and ample cash in the insurance companies allowed investing in equities
Most insurance companies invest primarily in bonds rather than equities. This reduces risk but also reduces return. Buffett very much targeted equities. By initially funding his insurance companies with high levels of equity and little or no debt and by then retaining all or substantially all insurance and investment earnings within the insurance companies he always had equity levels that were multiples larger than the minimums required by insurance regulators. It appears that debt was totally avoided in the insurance operations. The modest debt shown in the balance sheets above is likely associated with its non-insurance subsidiaries and, in the 1995 example, its finance operations.
Since financial risk amplifies the risks associated with assets, the lower level of financial leverage or financial risk allowed higher risks on the investment side including a heavy allocation to equities.
By maintaining a high cash level Buffett was never forced to sell investments at inopportune times in order to fund, for example, an unexpectedly high level of insurance payouts. The maintenances of ample cash also likely contributed to the ability to take higher risks with the remaining assets.
Equities are perceived by regulators as higher risk, though Buffett did not see his stock selections as risky.
Finding High Return Investments for the retained earnings
A huge part of Buffett’s success with Berkshire was in finding equities and businesses to invest in that provided high returns. If Buffett had retained all of Berkshire’s earnings but invested in assets that resulted in returns on equity of 10% rather than in the order of 20% then the growth in Berkshire’s book value per share would have been about 11,739% after 50 years or (amazingly enough) just 1.6% of the actual 742,783% that has been achieved. Continuously finding additional ways to average about 20% returns on equity despite an equity level that was compounding up at that average rate per share was a huge and necessary component of Berkshire’s success.
Those “ways” included investing extremely selectively in high quality companies whether through the stock market or by purchasing them outright. It also included many superior investments in bonds and arbitrage positions over the years.
Superior Stock Picking
It is well-recognized that Buffett exhibited superior stock picks skills. Somewhat bizarrely, the academics mentioned above “explained” this by noting that he favored low-risk, high-quality companies. This appears to “explain” away his stock picking skill by noting that he merely picked the type of stocks that tend to do the best.
Superior Business Acquisition Strategies
It is clear that Buffett made many extremely successful business acquisitions. He bought the right type of businesses, which usually came with the right kind of top manager and he did not over-pay. He avoided bidding wars.
Superior Business Management and motivation of managers
Through some combination of choosing the best managers and providing the right working environment and incentives and rewards (both financial and emotional – as in praise), Buffett was able to get extraordinary performance out of most of his subsidiary companies most of the time. I addressed this in detail in an article about Buffett’s management and motivation skills.
Becoming the Buyer of Choice
At some point, based on his reputation and way of doing things, Buffett and Berkshire became the “buyer of choice” for many large and successful family-controlled businesses. This led to some excellent acquisitions more or less falling into his lap and led to good prices for those acquisitions.
Achieved profit on insurance operations
Buffett has often explained how most insurance companies do not make an operating or underwriting profit on their insurance operations before considering the profit on investments. In contrast, Berkshire managed to make a profit most years on its insurance operations even before considering the profits from investing the insurance float.
The use of Insurance float and deferred taxes to fund assets
Buffett has explained that using insurance float to fund investment assets can be very beneficial but only if the insurance companies operate with a cost of float that is lower than the cost of using debt. Most insurance companies lose money on their insurance operations but make a profit overall by investing their insurance float. Most insurance companies face a high cost of float, usually not consistently lower, if any, than the cost of debt. Buffett and Berkshire however have managed to achieve a cost of float that has been below zero on average. This meant that the leverage that was provided by float, while it was not a large amount of leverage came at a “cost” less than zero. This boosted the return on assets by lowering the cost of funding the assets.
Another advantage of funding assets with float rather than debt was that float did not have a maturity date. As long as the insurance operations were growing the float would grow. Insurance claims would be paid out each year but the incoming premiums, after operating expenses, would usually exceed the payments and the float would grow.
Deferred income taxes represented mostly the income tax that would be due if the stock investments which had appreciated greatly in value were sold. This is not a legal liability until and unless the shares are sold and the capital gain realized. This source of funding has no interest rate cost. In addition this source of funding would tend to grow over the years as Berkshire grew and as Buffett tended not to sell and not to realize gains on his largest equity positions.
Together, float and deferred taxes provided a low or even negative cost way to leverage the equity return by allowing assets to be larger than equity. Again, however, Buffett’s use of leverage was modest in comparison to other insurance companies. The advantage was in the low cost of this leverage.
Discipline and patience
It is difficult to do justice in describing the level of discipline and patience that Buffett exercised. At times he severely curtailed the level of business in his insurance operations when he judged market insurance rates to be too low. He studied hundreds of investment opportunities each year but had the discipline to select only those very few that were the very best he could find. In the 1970’s he had the patience and discipline to buy a very large position in GEICO only after its price had fallen some 95%. This was despite the fact that he had known and admired the company for two decades prior to that. He always had the discipline to restrict his investments to fit a strict criteria which excluded many industries.
Buffett exhibited a laser-like focus on his goal of increasing the value of Berkshire on a per share basis.
Buffett has taken pride over the years in describing the extreme speed at which he was able to make deals and acquire companies. In each annual letter he has stated that he can provide a preliminary indication of his interest in a potential acquisition, “customarily within five minutes”.
Buffett also used speed in his huge reinsurance operation. He has described how the top manager of that business is able to give a same-day commitment on an insurance contract in the hundreds of millions of dollars. He indicated that no other reinsurance company operates at close to that speed.
Keeping it Lean
Head office staff was remarkably lean at about 11 to 14 for many years. In recent years it has “bloated” up to around 24. The extremely lean head office staff meant that there were fewer distractions from managing staff. It also set a great example of frugality that no-doubt influenced the managers of his subsidiary companies.
Running a Highly Concentrated Equity Portfolio
One certainly cannot beat the stock market averages by holding a diversified portfolio that mimics the market. Finding a handful of stocks that beat the market substantially allowed Buffett to beat the market. A concentrated portfolio in no way guarantees beating the market. But mimicking the market with a widely diversified portfolio would have precluded beating the market by any material amount.
Buffett has described how he set up his operation in a way that allowed him to spend most of his time on the all-important functions of finding the best investments. As Berkshire grew, it would have been natural to have spent most of his time on administration and management. Buffett did not allow that to happen. His letters indicate the ability to drop everything and focus immediately on an acquisition or other matter of great importance whenever that was required.
Placing Trust in managers and giving them full authority and autonomy
Buffett has described how he placed the utmost trust in the management of his various subsidiaries. He ceded full control and autonomy over operations to these managers. It seems clear that the managers responded to this trust by working very hard to earn it. This was also part of his strategy of freeing up his own time to focus on the investment process.
Providing managers with appropriate financial incentives
Managers were given simple and relevant financial incentives. Their pay was linked tightly to achieving a higher than normal return on the capital that they worked with.
Heaping public praise and encouragement on his best managers
Buffett has always used his annual letter to heap extremely lavish praise on his top managers. It has got to be very motivating for managers to be praised in such a widely-read public letter.
Keeping tabs on his companies and investments
While managers are left alone to run “their” subsidiary businesses, they must file frequent detailed reports to Buffett. These reports focus on weekly and daily sales volumes and on costs. The reports allowed Buffett to keep close tabs on operations and profitability.
Buffett was constantly aware of the mathematics of making returns. He always focused on making rational decisions. He never priced his insurance below a reasonable level just because others were doing it. He never did anything simply because others were doing it . He always acted in ways that he thought to be rational.
Investing in businesses as well as securities
Owning businesses outright provided some tax advantages as compared to owning stocks and earning returns through dividends. Buffett also found that at some times businesses were the better bargain and at other time stocks in the market were the better bargain. Being willing to choose from the two options assisted in the maximization of return on assets. He also chose bonds when those were the best option. And there was no fixed allocation to bonds and equities. The allocations changed depending on the relative attractiveness of each category at any point in time.
Separating the Insurance Business Into Two Parts
In each insurance operation he made management responsible for the underwriting profit and the growth of float and gave them no responsibility for the investment process. He expected his insurance managers to achieve an under-writing profit or at least a lower-than-average cost of float with no reliance on investment returns. By taking the management of investments out of their hands he assured that their attention was 100% focused on under writing profitability and profitable growth.
Controlling large capital expenditures at the top
Berkshire’s conglomerate nature allowed excess capital generated in one business to be used to grow another. By controlling the bigger capital expenditure decisions from the top, Buffett insured that mangers did not pour capital into their particular business when better opportunities were available elsewhere in Berkshire including by investing in stocks.
Buffet always had a huge amount of confidence in his own analysis. The fact that his approach was unconventional or unpopular never bothered him.
The ability to transfer earnings of subsidiary companies to other companies tax free
When Berkshire received dividends and interest from marketable securities there was income tax to pay. However, dividends from one subsidiary could be received and invested in another subsidiary without incurring income tax.
Wise consideration of income tax
Buffett has said that minimizing income tax was never the primary goal. But he certainly did defer income taxes and structure transactions in tax efficient ways when it made sense to do so. However, it should be noted that he was by no means aggressive in avoiding income tax. For example, unlike (as I understand it) most insurance companies he did not set up captive reinsurance operations located in tax havens to flow profits to those low-tax jurisdictions. I have never seen any commentator give Berkshire and Buffett credit for that.
Warren Buffett’s son Howard has said that people don’t understand just how tough Warren Buffett is. He did not like to do it, but he fired managers when he had to. He is an extremely tough negotiator. He tends to name a price and stick with it.
An immense will to win and be the best
Buffett has always displayed an enormous will to win. He made sure to measure how his companies stacked up. For example, he knew that Nebraska Furniture Mart had the highest single store sales in the U.S. and he was very proud of it. He has noted several times when his two pipelines ended up at the very top of the customer satisfaction rankings for pipelines. He is proud of the high returns his companies make and is proud when they can offer the lowest prices. Buffett has won many things. One was a Pulitzer prize for his tiny Sun newspaper, in the early 1970’s, for an article he suggested and helped write. He is a famously skilled and competitive Bridge player. You just don’t win as often and as big as Buffett has without having an enormous will to win.
A photographic memory
It’s my observation that Buffett has a photographic memory. I have witnessed him pull detailed facts and figures out of the air in answering hundreds of random questions. He has described how he had basically memorized Benjamin’s Graham’s book Security Analysis and knew the book better than Graham when he was taking classes from Graham.
Buffett has displayed great loyalty to his oldest friends and associates. Carol Loomis, for example has been editing his annual letter since 1977 and was a friend before that. He was enormously loyal to Katherine Graham at the Washington Post. He has frequently done business repeatedly with the same executives. When he has gained great trust and has great admiration for someone he very rationally chooses to continue to do business and associate with that person.
A total lack of pandering to Wall Street
Buffett has never played the Wall Street game of attempting to meet or beat the earnings expectations of analysts. He considers that a waste of time and considers that it would offer an unfair information advantage to analysts. Berkshire may be alone among S&P 500 companies in not doing quarterly or even annual analyst conference calls. This avoids a distraction and a demand on his time.
Constantly Reading, Learning and Thinking
Buffett has said that he reads 500 pages per day. He reads widely. He reads or goes through five newspapers per day. When he was young he studied every page of the Standard and Poors and Moodys summary reports on companies. His partner, Charlie Munger calls him a learning machine.
Unique Analysis Abilities
I have often witnessed Buffett’s ability to take a few numbers and relate them in uniquely insightful, useful and memorable ways. For example, he related the number of households being formed to the number of houses being built before during and after the U.S. housing bust. He calculated that all the gold in the world would form a cube only about 68 feet per side which he said could rest comfortably inside a baseball infield. He then noted that the market value of this imaginary gold cube was equal to 16 Exxon Mobils, all the cropland in the United States plus a trillion dollars. These kind of simple but powerful relationships give him a unique and fast insight into many things.
Although he has learned and adapted over the years, Buffett has also been remarkably consistent. In 2013 he included in the annual report a letter about pensions that he had written in 1975. Presumably his opinions had not changed. Reading his earliest letters one can see that his most basic views have not changed.
All of the above explains how he was able achieve such staggering growth per share at Berkshire. It’s interesting that while he has hundreds of thousands of fans so few people have truly tried to emulate his methods.
Shawn Allen, CFA, CMA. MBA, P.Eng.
February 3, 2015 (with minor edits to October 15, 2017)