David Fleer
Bristlecone Value Partners, LLC
12301 Wilshire Blvd., Suite 320
Los Angeles, CA 90025 USA
Work 1-877-806-4141
www.Bristlecone-VP.com


Berkshire Hathaway: In Praise of Synthetic Leverage

“Life is like a snowball. The important thing is finding wet snow and a really long hill.”

–Warren Buffett

A few weeks ago, Warren Buffett published his annual letter to shareholders of Berkshire Hathaway–one which we read with interest each year.  The letter’s opening page contains a performance table tracking the annual percentage change in Berkshire’s per-share book value, compared to the return of the S&P 500 Index. By this very basic performance measure, Mr. Buffett’s track record is remarkable, outpacing the S&P 500 by an average of 9.3% per year over the past 52 years!  

Buffett’s reputation as a savvy stock-picker is certainly well-deserved, but there is another critical element to Berkshire’s success which has “snowballed” over the last few decades: significant amounts of low-risk “synthetic” leverage obtained at near-zero cost.  Berkshire’s business model obtains this synthetic borrowing capacity in two principle ways: 1) through “float” on its insurance businesses and 2) through the accumulation of deferred tax liabilities on its balance sheet.

In any insurance business, there is a timing lag between when premiums are paid by the customer, and when a covered loss ultimately requires the insurer to pay out a claim.  For certain types of insurance (i.e. life insurance or property & casualty insurance), this timing lag can stretch over decades.  In the interim, the insurer gets to invest the funds from policy premiums in order to generate additional income.  This pool of assets to fund future claims–called “float”– is represented as a liability on the insurer’s balance sheet.  In Berkshire’s case, steady growth in their insurance businesses (augmented by acquisitions) has contributed to an astounding increase in the dollar value of float over the past 26 years:

 Source:  Berkshire Hathaway 2016 Letter to Shareholders

In effect, Berkshire is borrowing $91 billion from customers, which it can profitably invest for its own benefit until the money is needed to pay out claims.  Better still, Berkshire’s insurance subsidiaries have operated with an underwriting profit for 14 consecutive years, so more often than not, the company is being paid to use this money.  In 2016, Berkshire’s insurance businesses generated an after-tax underwriting profit of $1.4 billion, while the related float accounted for about 36% of the firm’s insurance-related investment portfolio. To contextualize what an attractive proposition this is, imagine a broker permitting you to borrow 36% of the value of your account and paying you 1.5% interest for that privilege!

In addition to the powerful insurance float, Berkshire also enjoys synthetic leverage in the form of deferred tax liabilities (reflecting taxes that have been accrued but are not yet payable).  As of year-end, Berkshire’s balance sheet reflected $77 billion of deferred tax liabilities, up 8 times since 2008:

 

Two line items account for most of that $77 billion.  First, Berkshire owns over $250 billion of marketable securities, many of which were acquired decades ago at very low cost. The difference between the market value of these investments and their historical cost is approximately $80 billion.  If Berkshire sells these investments, the unrealized gains become taxable at relatively high corporate tax rates, triggering an estimated $28 billion tax bill. Mr. Buffett, who has a keen sense of opportunity cost and famously remarked that his ideal holding period for investments is “forever,” would much prefer to keep that $28 billion compounding for Berkshire’s shareholders, rather than remitting it to the U.S. Treasury. To put this in perspective, Berkshire’s per-share book value has compounded at more than 10% annually over the past decade.  Therefore, the opportunity cost of paying off this deferred tax liability could easily be $2.8 billion per year–more than 10% of last year’s reported net income!

The second major component of Berkshire’s deferred tax liability–and one which has quickly ballooned in size over the past 6 years–is tied to the firm’s aggressive increase in capital spending (PP&E):

Most of this increase is attributable to two Berkshire subsidiaries: Burlington Northern Santa Fe (a railroad) and Mid-America Energy (a utility).  Both of these businesses require substantial annual investments in very long-lived assets, which generate modest but steady returns.  Some of these capital investments can be depreciated for tax purposes on an accelerated schedule (10-15 years), even if their actual useful lives–according to GAAP accounting rules–are much longer (30+ years).  This gives rise to a temporary disconnect in depreciation expense between the two accounting methods, resulting in a lower current income tax bill (and an associated increase in GAAP deferred tax liability).  Eventually, the fully-depreciated PP&E will be written down to the same value in both accounts.  In the interim, the accelerated depreciation method allows Berkshire to postpone a cash outflow, potentially for many years.

Added together, these two forms of synthetic leverage allow Berkshire to control about $168 billion more assets than it otherwise would.  As Buffett himself notes in Berkshire’s “Owners Manual”:

“Neither item, of course, is equity; these are real liabilities.  But they are liabilities without covenants or due dates attached to them.  In effect, they give us the benefit of debt—an ability to have more assets working for us—but saddle us with none of its drawbacks.”

In press accounts, Mr. Buffett is frequently renowned (justifiably) for his stock-picking abilities.  However, it’s important to realize that Berkshire’s success in recent decades owes more to Buffett’s careful cultivation of a unique corporate structure and culture.  The “snowball” he has spent 50 years building enjoys competitive advantages which will persist long after he is gone.

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