Wednesday, April 15, 2015
Chirkova, The Warren Buffett Philosophy of Investment
The Warren Buffett Philosophy of Investment: How a Combination of Value Investing and Smart Acquisitions Drives Extraordinary Success (McGraw-Hill, 2015) is a carefully constructed analysis of the key elements of Buffett’s investing prowess. The author relies heavily on previously published work, but she uses this material to present one of the most coherent accounts of Buffett’s achievement that I have read.
Take, for instance, her chapter on Berkshire Hathaway’s use of debt. When Berkshire purchases a company, “Buffett recommends that the acquired company reduce and gradually end its relationship with its bank. Berkshire becomes the company’s banker. This enables the company to take advantage of Berkshire’s credit rating.”
Chirkova continues: “A business achieves its best results when both sides of the balance sheet are well managed. Berkshire Hathaway pays considerable attention not only to searching for good investments, but also to optimizing its capital structure. This optimization requires selecting the appropriate level of debt. Although Buffett’s views on borrowing may suggest otherwise, Berkshire’s level of leverage cannot be regarded as very low.” (p. 173) Between 1976 and 2011 it averaged about 37.5%. Nearly all of this leverage came from the capital float of Berkshire’s insurance companies. In more years than not, the cost of this “borrowing” was negative, in some years highly negative, “as payouts were far lower than the premiums collected.” (p. 178)
Chirkova suggests that, despite Buffett’s claims that nobody can time the market, he has been a savvy timer in the catastrophe insurance business. Moreover, “it is not purely accidental that Buffett’s insurance business is oriented toward supercatastrophe insurance. In supercatastrophe insurance, the payouts are separated in time from the moment of premium collection by a considerable period. Losses are accounted for not in the year of the catastrophe, but once the damage has been assessed. At the same time, the premiums received are invested. The longer the period that the collected funds are held, the greater the earnings on the investment of these funds. Buffett’s investment capabilities allow him to invest premiums with better returns than those that would be available to other insurers. The outcome reinforces itself. Premiums are invested with greater profitability, which assists the insurance business.” (pp. 181-82)
In another instance of “watch what Buffett does rather than what he says,” he has actively participated in the derivatives market. Perhaps his best known deal was his sale of long-dated puts on the S&P 500, FTSE 100, Euro Stoxx 50, and Nikkei 225, executed in 2006-2008. Buffett received $4.9 billion for the sale, money that Berkshire could invest as it pleased. In retrospect, the timing of these trades may seem less than fortuitous since for accounting purposes Berkshire had to write off $10 billion in 2008. But this was only a paper loss, and Buffett had a real $4.9 billion to put to work in the depths of the Great Recession. Moreover, even if the equity indexes were to fall to zero, the maximum amount Berkshire would owe the buyers of the puts (at intervals between 2019 and 2027) would be $37.1 billion. And if Buffett gets an annual return of 10% on the $4.9 billion, then in 15 years he will have accumulated about $20.5 billion; in 20 years, $33 billion. It’s hard to imagine that he can lose on this deal.
Chirkova explores multiple facets of Warren Buffett’s investment philosophy as it has evolved, from numbers to reputation. She compares his strategy to those of Robert Merton and Peter Lynch, arguing that “the first of these two investors was practically the direct opposite of Buffett, and the second a near perfect clone.” (p. 108) She traces out his circle of friends, and even reveals that he doesn’t always drink cherry Coke.
If you’ve never read a book about Buffett’s investing skills, The Warren Buffett Philosophy of Investment is a great place to start. If you’ve already read twenty books about Buffett, you owe it to yourself to make this one your twenty-first. You will undoubtedly learn a few new things, and you may well find unexpected interconnections among things you already knew.