Sunday, November 26, 2006

>Buffett and Leverage

Warren Buffet picks are just those for a good fund manager, the reason he has done much better than even good fund managers is due to leverage.

"As always you have to be careful parsing what Buffett says and what he actually does. I'm surprised to hear him say he's never used much leverage -- then what does he call $50 billion in insurance float?"

"This means that over 6% of Berkshire's long-term results have been largely due to insurance float leverage. Without this leverage, Berkshire's returns would have been about 4% above the S&P 500, which puts Berkshire in the same category as a very good mutual fund. For example, the Sequoia fund is currently about 4.6% ahead of the S&P 500 over its lifetime.

Its something to think about when you're aspiring to beat the averages – that even Buffett's raw record without leverage, while impressive, shows how hard it is, perhaps, even impossible, to significantly outperform the general market averages. The leverage in Buffett's case is subtle and certainly lower-cost than straight debt, but it is there nonetheless, and without it he would have never gotten his world-class record. Buffett used float from his insurance operations to provide zero cost leverage to his stock portfolio."

"There have been many times in the last twenty-five years that Buffett's portfolio of marketable securities was "on margin" - ie the value of the stocks (and not cash or bonds -- just stocks) exceeded BRK's shareholder equity by 20-25%. You can say that insurance float has zero cost on average -- but in any given year it can and does sometimes cost more than straight bank debt (just look at the cycles in the reinsurance biz)."

It also explains his horror to find out that Gen Re had uncapped risk exposure in its contracts after 9/11. Buffett certainly sweated out the rollover and renewal of every Gen Re reinsurance contract.

While I understand Buffett's point -- its a bit at odds with Buffett's own methods, if you study his record carefully. He's been using leverage all the time (Berkshire partnerships partner money, Blue Chip Stamps unredeemed green stamps, insurance float) -- almost for his
entire career and it has helped make his returns better than what they would have been. Avoiding leverage -- I don't think so!


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