For decades, Warren Buffett has been the face of investing. Investors, young and old, see him as a friendly grandfather figure who doles out wisdom about life and the markets. Attending his Berkshire Hathaway annual shareholder meeting is a rite of passage for many serious investors.
Of course, Buffett attained this status of being able to move the markets with his words through his incredible investing performance for more than six decades, returning 20% per year on average compared to the S&P 500’s 10.2% since 1965.
Some investors think of Buffett as an investing god whom mere mortals can only hope to emulate in their investments — but is this true? Does Buffett have an uncanny ability to choose stocks, or is there something else that explains his continued performance? Follow along as we take a deep dive into the reasons behind his remarkable success.
1. Buffet Made Good Use of Insurance Float
One tactic that Buffett hasn’t been shy about in his investment letters is his use of floats. For those unfamiliar, a float is any pot or stream of money that is set aside and will have to be paid out in the future.
This doesn’t necessarily sound exciting, but let’s look at Buffett’s representative example: insurance floats — specifically, life insurance. Life insurance provides a passive income stream from policyholders' premiums, which can go on for decades until the policies must be paid out.
Using high-level models, statistics, and actuarial sciences, insurance companies know roughly how much they need to be able to pay out in the future, as this amount is a multiple of their current stream of premiums.
Fearing inflation or sudden waves of policy payouts, these insurance companies invest these premiums. Most insurance companies do this highly conservatively, as their primary business is insurance and not stock picking.
This brings us back to Warren Buffett and Berkshire Hathaway. One of Buffett’s earliest significant investments was in GEICO, a small insurance company for government employees at the time of his investment in the mid-1990s. By acquiring an insurance company, Buffett understood that he was essentially securing an interest-free loan. He would receive “free” cash to freely invest, which would only have to be paid back decades later. Since then, Berkshire Hathaway’s insurance holdings have continued to grow. In 2021, profits rose to $75 billion.
The insurance business has become a core Berkshire Hathaway holding, essentially acting as free leverage for Buffett. But unlike leverage that you or I might take on, he pays no interest, never has to worry about margin calls, and can easily hold the debt for decades. Meanwhile, Buffett has recommended that others avoid leveraging at all costs.
2. Buffet Invested in Quality and Value
Buffett is a well-known value investor through his shareholder letters and in his work as a student under the “Dean of Wall Street,” Benjamin Graham. The latter is widely considered the father of value investing.
Comparison: Value Investing vs. Growth Investing >>>
However, before starting Berkshire Hathaway, Buffett invested through his partnership, which one can think of like a proto–hedge fund. In this case, a limited number of investors pooled their money together for the young Buffett to manage. In exchange, Buffett received a performance fee — similar to the standard rate in hedge funds today.
Buffett has also evolved as an investor over time, especially as Berkshire Hathaway grew into the behemoth it is today.
“Cigar Butt” Stocks
Buffett’s strategy back then was a direct result of studying under Graham — Buffett would look for small, overlooked, and unknown companies trading at discounts that wouldn’t make sense in an efficient market.
For example, one of Buffett’s favorite kinds of stocks were called “Cigar Butts” — companies that only had one or two puffs left, but those puffs were “pure profit.”
Examples of these companies include those trading at a discount in relation to the total cash on their balance sheet with liabilities subtracted. These companies could close and return the excess cash to shareholders, which would still provide them with a profit despite the company closures.
A New Strategy
When Buffett moved on to Berkshire Hathaway, his partner Charlie Munger convinced him that he needed a new strategy — buy successful companies at good prices rather than average companies at high prices and then hold them long-term.
This change of strategy was likely directly related to Buffett ending his investing partnership. He made clear in his final letter that his market strategy was not working in this new market environment. It’s safe to say that his “new” strategy has more than passed the test of time!
The investment management firm AQR, which specializes in using quantitative data, wrote an entire paper dedicated to breaking down Berkshire Hathaway’s investing strategy. Through data analytics, they found Buffett:
- Overwhelmingly and consistently bought large-cap value stocks that had low book value to market value,
- Completely avoided momentum stocks,
- And mainly bought low-beta stocks or stocks that are defensive
AQR’s analysis found that these factors accounted for nearly the entirety of the excess returns found in Buffett’s public market portfolio. This makes sense, as paper after paper has shown that value investing beats the market and growth or momentum investing over time.
Buffett's focus on large-cap companies meshes well with his “safety first” style of investing. Overall, large caps are less risky than small-cap stocks as they can always tap into the global debt markets or sell more equity to raise capital.
Finally, the fact that Buffett has completely avoided momentum has meant that he has emerged unscathed from most bubbles, such as the tech bubble of ‘99. While Berkshire Hathaway underperformed in terms of the Nasdaq leading up to the bubble bursting, he more than made up for it in subsequent years.
3. Buffet Understood The Permanent Capital Advantage
It's easy to compare Buffett’s returns to those of other well-known hedge fund managers. In a way, though, this is the wrong comparison to make. Berkshire Hathaway is structured very differently than all other hedge funds, and this structure gives Buffett a huge advantage over his investing competitors.
Almost all hedge funds are private companies and are open exclusively to institutional investors or accredited investors, meaning individuals with high net worth. In these cases, investors agree to invest a specific amount with the hedge fund manager. Still, as hedge funds trade in highly liquid instruments such as stocks, these investors also demand similar liquidity. Generally, an investor has the right to give their hedge fund manager one quarter’s notice when they want to withdraw funds, and the hedge fund manager must comply.
Compare this to other fund structures, such as private equity (PE) funds or venture capital (VC) funds, where investors agree to lock up their money for five to twenty years. These locked funds provide these PE and VC funds with peace of mind, as they deal in highly illiquid securities that can take years to pay off.
On the other hand, the hedge fund manager must constantly hold a portion of their holdings in cash to meet any redemptions. Or they must scramble to sell their positions to meet a surprise wave of redemptions during a market panic. The hedge fund manager then is forced to sell their positions at the worst possible time — theoretically, when the best deals are to be had.
The Best Way To Use Other People’s Money
Back to Berkshire Hathaway’s structure: Having locked up capital is a huge benefit to funds. Buffett takes this idea one step further by creating permanent capital. Berkshire Hathaway is a listed stock. So when you buy a share, you don't put your money into a fund’s pool. Instead, you buy the share from a shareholder. Your buying and selling of Berkshire Hathaway stock has zero impact on how much money the company has to invest.
In this way, Buffett has all the potential benefits of using other people’s money. Indeed, when he liquidated his partnership, he offered his partners the option of converting their stakes into Berkshire Hathaway shares, which has raised capital through debt offerings. Thanks to their sterling credit rating, this cost Berkshire Hathaway very little.
This means that Buffett never has to worry about investor redemptions. And he can even raise more money from capital markets whenever he sees fit. That's a huge structural advantage — so much so that major hedge fund managers like Bill Ackman have sought to try to recreate this structure within their funds.
The Bottom Line: Buffet Stayed the Course and Outperformed the Market
For the three reasons outlined above, Buffett has consistently outperformed the market and his peers, decade after decade. Of course, Buffett is not an average investor who happened to put a superior structure in place to give him these returns.
Buffett is indeed a genius, but perhaps in a different way than what people traditionally think. After all, no one was thinking about how insurance premiums could be used to leverage investment returns in the ‘60s. Similarly, no one was thinking about how important permanent capital could be for a fund manager. These are innovations that Buffett championed and profited from.
“Buffett is indeed a genius, but perhaps in a different way than what people traditionally think.”
Additionally, while it's true that back-testing for a portfolio of value stocks has traditionally beaten the market over time, this is only apparent now because we have so much data.
Back in the ‘60s, Buffett consistently invested this way regardless of periods of underperformance. This was due to his unwavering belief in the logic behind value investing. This ability to stay the course and avoid panic during downturns has nothing to do with the way that Berkshire Hathaway is structured and everything to do with Buffett as an investor.
The good news is that these qualitative traits of Buffet are ones that everyday investors can mimic — even if buying an insurance company and listing it may be beyond the reach of most of us.
There have been a number of books about Warren Buffett and his style of investing. Here are some we recommend:
- Buffettology by Mary Buffett and David Clark
- The New Buffettology by Mary Buffett and David Clark
- Security Analysis by Benjamin Graham
- The Intelligent Investor by Benjamin Graham and Jason Zweig
- Value Investing: From Graham to Buffett and Beyond by Bruce C. N. Greenwald, Judd Kahn, Paul D. Sonkin, and Michael van Biema
- Buffett: The Making of an American Capitalist by Roger Lowenstein