Monday, February 16, 2015

How Ordinary Investors Can Generate Float Like Buffett

Warren Buffett is one of the best investors in the world. The most interesting fact about him is that he started making a lot of money after retiring twice – first time in 1956 and the second time in 1970. The first retirement idea he had was to run a hedge-fund like partnership, which he closed in 1970. The second retirement idea he had started in the 1960s, when he bought a struggling textile factory called Berkshire Hathaway at a heavy discount to book. While he calls this acquisition one of his biggest investment mistakes of his career, he has nevertheless managed to transform Berkshire Hathaway from a struggling company to a thriving conglomerate with a $300 billion market capitalization. This was mostly due to the fact that he is a learning machine that has accumulated business knowledge at a rate of 70 hours per week for 70 years. Accumulated knowledge is like compound interest, which pays tremendous dividends over time. For example, he purchased a massive block of Coca-Cola stock between 1988 and 1994, after using the product for over 50 years. Another example includes his ivnestment in IBM in 2011, after reading the annual report for the preceding 50 years, and investing in a company that competed with Big Blue in the 1950s.

While his investing prowess is unmatched, he has had a few levers within his control that helped him in his ascend to one of the world’s wealthiest people. The major lever that helped him earn his first $20 million were the performance fees he earned on Buffett Partnership partners. In fact, if returns exceeded 6% for a given year, he earned 25% of the profits above that threshold. As the level of assets increased, and as he was able to compound partners’ money at market-beating returns, his share turned him into a millionaire by his early 30s. By the time BPL was closed in early 1970, Buffett was worth over $20 million.

This is where the next chapter of Buffett’s investing prowess started. He was able to transform Berkshire into a powerhouse, by investing heavily into insurance companies like National Indemnity, GEICO, General RE to name a few. Insurance companies generate so called float, which is the amount of premiums received by policyholders. Overall, the amount of insurance premiums received tends to increase over time, which provides cash in the coffers of insurance companies. This cash is ordinarily invested in fixed income instruments like corporate bonds by most insurance companies. In general, his companies have managed to turn a profit in the difference between paying out claims and receiving premiums from policyholders. In the hands of Warren Buffett, that float was golden, as it represented free money he is given to invest, and was being paid to hold it. He was able to use the float generated by insurance companies as a defacto free leverage that allowed him to purchase even more businesses and more stocks, that further magnified his returns. In essence, he is a superinvestor, and his results have benefitted immensely from this free form of leverage.

However, I believe that even an ordinary investor with an ordinary investment records can benefit from the type of leverage, that float provides. The big issue is that as an ordinary investor who does not have tens of millions of dollars to buy an insurance company outright, it is almost impossible to use the same lever as Buffett. However, as I have been thinking about it, I could think of a few scenarios within the reach of ordinary dividend investors, where they have access to float.

1) When you purchase quality dividend paying stocks, the investor receives dividends today. However, as the company earns more, and pays more in dividend income over time, the shares become more valuable over time. If the investor decides to sell, they would have to pay hefty capital gains taxes on their money. In essence, the amount of the unrealized capital gain times the taxable rate of the shareholder is a defacto interest free loan from the US government, that subsidizes the long-term buy and hold investor. As long as the investor never sells, they never have to repay that float.

2) When you put investments in a tax-deferred account such as an IRA or 401 (k), you are receiving a tax deduction today, but promise to pay taxes on distributions at some future point in time. As a result you can end up purchasing dividend paying stocks at an immediate 25% discount. As you earn more dividends on investments, and as they appreciate in value over the course of several decades, the potential liability to the IRS increases. However, until you have to make distributions at the tender age of 70 and ½ years of age, you don’t have to pay taxes. Those tax liabilities are there, and in the eyes of Uncle Sam are not yours, but they nevertheless provide an interest free loan, and a sort of float for you to use in the meantime to propel your family to riches.

3) When you sell puts on a company stock, you are contractually obligating yourself to purchase the stock at a predetermined price and date, if it trades below the strike price. You are paid an option premium for this trade, whose value depends on factors such as interest rates, volatility of the stock, dividend yields and how far the option strike price is from the current stock price. If the stock is above the strike price at options expiration, you can keep the premium. If the stock price is below the strike price at expiration, you have to purchase the stock, even if it is much lower than the market price at the time. The premium you earn can be used to buy more stock. Either way, it is a win-win for the option seller, since they either end up with option premium cash in their account or with shares in a good quality company at a lower price than the competition.

4) The other type of float that ordinary investors can generate includes taking on margin loans and buying stocks on margin. You are therefore using borrowed money from your broker when you buy stock on margin. If you use brokers like Interactive Brokers, you are paying something like 1.60%, which is low. If you purchase a stock like Coca-Cola (KO) or General Mills (GIS), which pay around 3% today, and are expected to grow dividends over time, you could end up having dividends pay off the interest and principal. As long as the dividend is higher than the amount of interest paid on the margin loan, it is possible that eventually the dividend will pay for the stock. The downside to this strategy is if stock prices tank, and you need to put more money into the account. This is the dreaded margin call. If you do not have any more money to put, you can effectively lose everything. This is why purchasing shares on margin is so risky. Even if a stock price declines temporarily, and you know underlying fundamentals are great, the market participants might disagree with you and keep prices low for longer than you can remain liquid.

Full Disclosure: Long GIS, KO, BRK.B

Relevant Articles:

Warren Buffett Investing Resource Page
Selling Puts: Pros and Cons for Dividend Investors
Warren Buffett is now working for me
The Most Successful Dividend Investors of all time
How to never run out of money in retirement

2 comments:

  1. Or, you could purchase futures contracts on indexes or treasury bonds and leverage yourself up virtually interest free. You would just pay the commission. You would also have much less to worry about margin calls, as the margin rates on futures are incredibly low compared to regular stocks.

    With Interactive Brokers, you can also purchase mutual funds, and after 30 days, the margin on those funds drops to 25%. You could purchase stock index mutual funds, or bond mutual funds, and after 30 days enjoy a good bit of leverage with 1/2 the margin of regular stocks.

    ReplyDelete
  2. Suggesting that writing options is akin to insurance float is misguided.

    Insurance float is so valuable because the probabilities of payout follow a normal distribution.

    Options do not.

    ReplyDelete

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