Legendary investor Warren Buffett released his annual letter to Berkshire Hathaway shareholders over the weekend, sending many “experts” and investors into a frenzy as they try mimic Buffett’s investing style and, therefore, his profits.
But here’s the thing…
You shouldn’t try to.
I know that’s heresy in an era when the Oracle of Omaha is rightfully lauded as one of the world’s greatest, but simply mirroring what he does will not get you where you want to go. Chances are, it won’t produce the returns he gets, either.
Reason No. 1: Buffett Plays by Different Investing Rules
It’s well-known that Berkshire Hathaway has averaged an annual return of about 20% in the 52 years since Buffett got to work there. According to Buffett’s 2017 letter to shareholders, the company added more than $27.5 billion in net gains across 2016.
No ifs, ands, or buts about it… that’s a fabulous track record over a very long period of time. It’s consistent, it’s undeniably robust, and it’s worth noting that the S&P 500’s average annual gain over the same time frame was only 9.9%.
However, it’s also misleading.
There are dozens of books that will tell you Buffett has his method down cold and that he’s a master at planning long-term moves and spotting undervalued companies with low-risk, high-upside prospects. And that’s true.
But if Buffett were given a dose of truth serum before being asked to divulge his investing secret at a TED Talk, I suspect he’d give a one-word answer: leverage. Without that, his returns wouldn’t be all that great. In fact, according to The Economist, they would have been “unspectacular.”
People forget that Berkshire Hathaway, in addition to being a conglomerate holding company with a vast array of investments, is also an insurance company. Like all insurance companies, it commands a float – money that is counted twice because it’s been paid out by insurance carriers, but will have to be returned later to pay out a fraction of premiums as required by law.
Berkshire Hathaway’s float – which now stands at a formidable $84 billion – essentially functions as a massive pool of capital it can borrow at an estimated 2.2% interest. That’s three full percentage points and then some below the going rate if you or I were to try and obtain similar financing, or the average short-term financing costs of the U.S. government over the same time frame, according to The Economist.
In other words, Buffett is banking the big bucks because he’s leveraged up to his eyeballs and, like most insurance companies, has a really large investment company operating by virtue of the insurance premiums it collects.
Let me give you an example of what a difference this makes and why leverage is a dirty little secret.