If there’s one thing that financial commentators (me included) love doing its name-dropping Warren Buffett. I mean nearly everyone loves a succinct Buffett-ism from his library of quotes, or to talk about a particular stock he’s eying up at any given moment. 90% of the time though that comes at the expense of downplaying crucial parts of his life and career in order to concentrate on the various approaches he’s taken to picking stocks over the years: from the deep value cigar butt type stocks in the early days, to the switch to fairly valued high quality stocks when Berkshire Hathaway was a lot larger (and he was already exceedingly wealthy).
There’s a neat quote from around 1999 where Buffett basically says he would be able to generate returns of 50% a year with a sufficiently small enough starting capital (I think it was $1m in his example). One of his numerous biographies also explains that a few years later a friend handed him a book on Korean stocks, with Buffett using his own personal portfolio to find good investments there. These are the kinds of things that come up in financial media; lovely to read, but with less emphasis on the entrepreneurialism and great business mind that made him the wealth he is famous for today.
Don’t get me wrong there’s a lot to learn by going over the the stock picking side of Buffett – whether that be the early years or later on. The stakes he built in Coca-Cola and Wells Fargo are great lessons in long-term wealth creation and the power of compounding in high quality businesses for example. One would expect that in the years to come some of the more recent acquisitions like Burlington Northern Santa-Fe will get added to that list as well. The early years too when he was mulling over Moody’s manuals finding deep value stocks offers great insights to value investing. The fact that the internet allows us to collect more data in twenty minutes than he could in a day back then probably makes it tougher, but it won’t stop people from emulating his approach.
Buffett: The Entrepreneur
In his early years he was charging 25% fees over 6% profits in the Buffett Partnership. Some people compare that to modern day hedge funds charging two and twenty (2% of assets and 20% of profits that pass a certain threshold) which seems a bit unfair. In other words the modern day fund managers get paid whether the fund does good or bad in any given year. If the Buffett Partnership suffered loses then he would take a hit too. If it earned less than 6% then Buffett wouldn’t earn the fees. That’s a level of risk-taking that defines real entrepreneurialism.
As it turned out the Buffett Partnership did exceptionally well, compounding at 30% plus between 1953 and 1969 (before fees). Seven investors at the start of the fund contributing a total of $105,000 (plus $100 from young Warren to make $105,100) grew to 300 investors and a total of over $100,000,000. What’s the difference between Buffett the stock picker and Buffett the entrepreneur? Well, in 1956 Buffett had a net worth of $100,000. By 1959 that had shot up to $400,000. He reinvested his fees, and the partnership was a source for the type of wealth that you get when you start your own successful business. Nowadays that difference probably adds up to about $50bn.
Sure he was picking great stocks but he was also using leverage, a streak of activism and the subtle advantages that vehicles like Berkshire and insurance underwriting would go on to provide. Roughly three-quarters of Berkshire’s value is tied up in insurance businesses. Using the premiums creates a stream of cheap cash flow that can then be allocated to other businesses. You combine that with a superb allocator of capital like Buffett and Charlie Munger and it’s a huge source of the returns that have compounded at like 21% annually for the past fifty years. Again that’s real entrepreneurialism: seeing and doing what other people aren’t (or cannot). Buffett himself alludes to this in correspondence to shareholders, like this quote from a letter to them in 1996:
Berkshire has access to two low-cost, non-perilous sources of leverage that allows us to safely own far more assets than our equity capital alone would permit: deferred taxes and the “float”, the funds of other that are insurance business holds because it receives premiums before needing to pay out losses.
The deferred tax-liabilities bear no interest charge and the float allowed them “free” money as long as the insurance underwriting broke even. In other words it was like getting the benefits of debt-leverage but without the downsides. Back then the combination of deferred tax liabilities and the float was totalling about $12bn.
These kinds of deals permeate through Buffett’s and Berkshire’s history. He picked up two Omaha insurance companies back in the 1960’s for $8m when they had a combined “float” of over $17m. Much of his “stock-picking”, for example, is done with tax-advantages in mind. In the later years the size of Berkshire gave him access to types of deals that would be almost immediately value accretive, but which others just wouldn’t people to replicate: the deals he stuck during the financial crisis with Goldman Sachs and General Electric for example.
I’d imagine if Buffett was just a regular Joe Bloggs picking stocks he’d still be immensely wealthy. He would probably be like a turbo-charged version of one of those awesome stories of “secret” millionaires – regular people who squirrelled savings away into high quality stocks and other investments that turned out to be compounding machines. These are people who acquire assets and cash flows well in excess of the income provided by their regular jobs by investing in other people’s output. But Buffett was never built that way – he’s an entrepreneur and a businessman. He invested as much in his own output as those of others.
That’s what explains the ginormous wealth he has built. You can’t ignore it – 99% of his wealth wrapped up in Berkshire Hathaway. Warren Buffett’s undoubtedly a great stock picker – few have proven more adept at allocating capital, but he’s also a great businessman and entrepreneur as well. That ultimately explains why he’s worth billions and not millions.