If Warren Buffett had to start today (without worrying about old age), what would be his investment strategy so that he could reach the multiple billions in wealth he currently has? Would it be possible?
If you and your spouse had invested in the exact same stocks at the exact same prices as Warren Buffett did through Berkshire Hathaway, would you and your lovely spouse be worth $74 billion today, as shown in the chart above?
It depends on whether you were using long-term borrowed money or “OPM” at extremely low (i.e. negative) rates to fund those exact same investments.
- Mr. Buffett has and continues to borrow or use “OPM” or “Other People’s Money You Owe” year after year, at an extremely low cost to achieve a significant portion of Berkshire Hathaway’s remarkable returns. Note: This is not other people’s money that he is given to invest per se like a hedge fund, private equity fund or mutual fund managing other investors’ capital. In these aforementioned cases, these funds are given investor capital that is not borrowed; the returns generated by investment managers using investor funds are shared with the investors. In Buffett’s case, he was able to use borrowed funds or OPM liabilities with which to invest, such that he did not have to share his returns with the lender of those funds – only the cost to borrow or interest and principal was owed.
- And even better for warren Buffett, he has been PAID to use this OPM or borrow money. This further boosted his returns. He has had a zero to negative cost of borrowing. Being paid to borrow would be comparable to a student taking out a 5-year student loan for $100 and paying back only $95 at the end of the 5 years with zero interest. The student pockets $5.
- In summary, even though the stock you and Mr. Buffett bought may have gone up the same 5% for the year, he’s achieving 2.0x-4.0x the 5% return you’re getting because of OPM that he was being paid to borrow.
To start with an example, let’s say you, Mr. and Mrs. RateShark, who are hunting for a decent rate of return on your own money, buy a house for $100, putting all $100 of it down without taking out a mortgage.
Mr. Buffett buys a house exactly like yours right next to your house for the same price of $100. However, Mr. Buffett uses $50 of his own money and takes a $50 mortgage from the bank. Assume the mortgage has a 2% interest rate.
Say in one year, the value of both your house and Mr. Buffett’s house go up by $10 or 10%. So each house is worth $110 at the end of the year.
- So if both the RateShark family and Mr. Buffett were to sell right at that point, you both would be seeing $110 coming in from the sale of your homes. For the RateSharks, you will have achieved a return of $10 for a 10% return on your initial $100.
However, for Warren Buffett, he gets cash inflows of $110, too, but what is then deducted is:
-$50 mortgage principal paid back to the bank
-$1 or 2% interest on the $50 mortgage
So $110 – $50 – $1 = $59 goes into his pocket.
- $59 is a $9/$50 or 18% return for Warren Buffett on the $50 Mr. Buffett put in. 18% is almost double the 10% return you, Mr. and Mrs. RateShark, got on your initial investment of $100.
This is a common misunderstanding of how Warren Buffett and Berkshire Hathaway achieved such immense wealth – that is, at least half the returns were generated using 1.6x-2.0x asset leverage, meaning for every dollar of Berkshire’s own money put into an investment, Berkshire also borrowed another $0.60-$1.00 to invest alongside its own money, juicing the actual return on its own money down.
What would now be even better for Warren Buffett is if he had been able to get a longer maturity mortgage or other form of borrowing or OPM that he didn’t have to pay back right away at the end of the year. Or if he could borrow $1.00 at a NEGATIVE interest rate – needing to pay back only $0.95 of it. That is, getting PAID 5 cents to borrow $1.00.
What this means, using the same example above:
Again, Mr. Buffett gets cash inflows of $110, but what is NOW deducted is:
-$50 mortgage principal paid back to the bank
+$2.50 or +5% profit added from the $50 mortgage
(Essentially, this is the same as paying back the bank only $47.50 of the original $50 mortgage borrowed.)
So $110 – $50 + $2.50 = $62.50 goes into his pocket.
- $62.50 is a $12.50/$50 or 25% return for Warren Buffett on the $50 Mr. Buffett put in. 25% is 2.5x the 10% return you, Mr. and Mrs. RateShark, got on your initial investment of $100. 25% is also 7 percentage points higher than the original 18% Mr. Buffett was getting when he was paying a 2% interest rate on his $50 mortgage.
- And remember, the value of the purchased asset, the house, only went up 10% from $100 to $110.
You may be asking where in the world can someone be paid to borrow money? Well, there are several places. Insurance is one industry, only if you can underwrite profitably. If you collect premiums from policyholders, this is a source of OPM. Then, if you pay out claims in an amount less than what you collected as premiums, you just got paid to borrow or use this OPM. Insurance has been Buffett’s primary source of OPM for most of Berkshire Hathaway’s history. What’s ironic is that, in the past 50 years or so, insurers on average have not underwritten profitably. If it’s not clear how collecting premiums from policyholders is the same as borrowing money from them or why insurers have trouble writing profitably, I elaborate on that below.
OPM or leverage or borrowed money is a double-edged sword as it can amplify your positive AND negative returns, and can be especially punitive if it comes at a high cost. Some have asked, “Aren’t mutual funds and hedge funds using OPM by investing other people’s money?” Not quite – here I am specifically talking about Other People’s Money that You Owe – investing other’s money is not borrowed money per se. Because if you borrow money, you only owe the principal and the cost of using that principal; if you invest others’ money, they get to keep the majority of the returns you’ve generated for them less some management and performance fees, if any. This is a big difference. What Buffett did was he sourced long-term “friendly” OPM at an extremely cheap cost and respected the leverage by using just enough to boost the returns on very safe stock investments.
Warren Buffett wrote in 2004:
“Indeed, had we not made this acquisition [of our first source of OPM, an insurance company called NICO, for $8.6 million in 1967], Berkshire would be lucky to be worth HALF of what it is today [at $373 billion market cap in 2014].”
For the last few years, as I keep learning and broadening my