How Berkshire Hathaway Makes Money (Derivatives)

In a paper written last year, a group of hedge fund professionals and academics claimed to have “discovered” how famed investor Warren Buffett makes his money. The outstanding returns experienced by Berkshire Hathaway (Buffett’s firm) can be explained by two main factors:

(1) wise investments in undervalued, safe, blue-chip secur it ies and (2) extremely agreeable funding terms leading to economical leverage.

By punting on temporarily cheap assets with lots of borrowed funds, and by being able to borrow
cheaply, Buffett has been able to reach legendary status among the investment community.

In the words of the paper’s authors: “Buffett has developed a unique access to leverage that he has invested in safe, high-quality, cheap stocks and these characteristics largely explain his impressive performance.”

Here we focus on the funding side of the equation, leaving the stock-picking prowess analysis to others. Where is Berkshire get t ing that vast and affordable funding rom? How is Buffett being able to erect the wall of economical leverage that makes his returns so mouth watering?

Simply stated: by being willing to take on a lot of risk. For a fee, of course. Berkshire sells insurance and reinsurance policies into the financial markets. It also sells derivatives. ‘All of those sales generate (for the most part, upfront) premiums from those purchasing protection from Berkshire. Those premiums can amount to a ver y large sum.

Buffett then invests that money, an activity that should lead to interesting returns given his track record. Given that a lot of the sold insurance policies and derivatives contracts may take a long while, if at all, before Berkshire has to make any loss payouts, Buffett can make good use of the premium collected for many, many years.
The hope is that any eventual loss payment is both lower than the premium initially collected and long to come.
If Berkshire breaks even, that is if the eventual insurance claims and derivatives payouts equal the amount of premium received, Berkshire would have received the equivalent of zero-cost financing for all that period of time (plus any returns obtained from investing the premiums ) .

Were Berkshire to actually enjoy underwriting profits (payouts lower than the premiums ) , the company would have, ineffect, enjoyed negative cost funding.

This is what the paper’s authors mean when they state that Buffett enjoys the significant advantage of having unique access to steady, cheap, leverage. In the Sage of Omaha’s very own words:

Full PDF here , source here.

H/T Climateer Invest