Warren Buffett's bet against hedge funds had an 'unforeseen investment lesson'

The following contributed to accumulation of high-return assets. For example, he related the number of households being formed to the number of houses being built before during and after the U.

Special Investigation: The Dirty Secret Behind Warren Buffett’s Billions

Anyway, the chart plots miles per gallon X-axis vs avg car price Y-axis , the chart actually made no progression to the right more MPG while rising steadily during the 80ss.

I understand using MPG as a scale to measure industry and company advancements is ignoring a lot, but bear with me for this example. Fuel efficiency barely crept up while maintaining bare minimum…. Volvo is going fully electric in a couple years! Was this a ridiculously long tangent about MPG and free markets?

No, well maybe some of it was…but allow me to get back to the main point. The Prius was one of many signs that the technology for EV existed. Specifically, THAT is an example of management resisting the institutional imperative to buck the trend and lead into more promising initiatives. GM, Ford, and all of the other automakers are keen examples of management resisting the institutional imperative and being complacent.

What is the return on equity? Companies add to their capital base by making money and holding onto it — aka retained earnings. Obviously, any non-suicidal company is going aim to increase overall earnings.

Manipulative companies will take measures to increase earnings per share in place of overall earnings though. Usually, this is the effect of an inability to increase earnings.

For example, when companies buy back shares, they increase EPS but not earnings. Certain companies may hide declining prospects and worsening conditions by engaging in share buybacks.

He also excludes all non-recurring extraordinary items which are unrelated to the business. That being said, a good management team will consistently achieve good returns on equity while employing a manageable debt level. Debt levels vary greatly across industries so the nature of business must be factored into the question. Continuing and building on the aforementioned earnings theme, the ultimate value of any company is its ability to generate a surplus of cash, via earnings.

However, a company with high earnings may have a high fixed asset to profit ratio. This means to maintain ongoing business, the company has to dump its earnings into investments just to keep the business running. These capital expenditures will deplete its cash balance going forward. Obviously, this handcuffs the company and just reinforces the inability for the company to exit the vicious circle.

The company must drive static earnings to pay for static cost of fixed assets. OE is calculated by adding depreciation, depletion and amortization charges to net income and subtracting the capital expenditure required to maintain economic position and unit volume. OE reflects the true cash flow position of a company. Some enterprises like a real estate development for example require heavy expenditure at the start and very little later on.

Others, like manufacturing, require regular expenditure on plant upgrades or the business slips. OE is an attempt to provide a cross industry analysis measure. What are the profit margins? The paradox exists where managers of high-cost companies tend to continually add to their overheads whereas the managers of low-cost operations take pride in lowering their expenses. Any money spent on unnecessary costs deprives shareholders of extra profits.

The reduction of unnecessary expenses is a consistent theme of effective managers. Proper attention to profit margins helps Buffett avoid companies which are complacent to expenses.

Has the company created at least one dollar of market value for every dollar retained? In other words, over the long term, every dollar of retained earnings will be reflected with a dollar of market value. Buffett responded optimistically because he has a longer, historical perspective on world events.

Buffett started investing in Buffett said he's invested through fourteen U. He's invested through the Cuban Missile Crisis, civil rights conflicts, recessions, wars, and bank failures.

Despite the disagreements, "This country really, really works This is a remarkable country. We have found something very special," he reminded the audience. Buffett believes that you can become--to a large extent--the person you want to become. You can accelerate your success by emulating winners. In , Buffett said, "Just pick out the person you admire the most and sit down and write out the reasons why you admire them.

Buffett said to look at things like personality, character and temperament. Berkshire does leverage its equity. But it has used far less leverage than most publicly traded insurance companies and its leverage is not high even compared to most non-financial companies. The normal way to achieve leverage is through debt. But debt costs money for interest payments. For much of the time that Buffett has controlled Berkshire, interest rates on even high quality corporate debt were high.

However, as demonstrated below, Berkshire used little or no debt in its insurance and investing operation. It did use debt in its small lending operation and in recent years in its utility and railroad businesses. Float represents money ear-marked for future insurance claim payments that meanwhile can be invested. Most insurance companies face a positive cost of float. In addition, Berkshire used deferred income taxes as an interest-free form of leveraging.

Berkshire had an unusually large amount of deferred income taxes over much of the past 50 years. This was due in large part to the fact that it maintained large unrealized gain positions in many stocks. That may not seem like a lot but consider that money compounding at Such is the power of compounding. A little higher rate of compounding goes a very long way when you talking about 50 years. Berkshire achieved a high return on assets. In the absence of high leverage, the way to achieve a high return on equity is to achieve a high return on assets.

It is therefore clear that Buffett and Berkshire Hathaway achieved a relatively high return on assets compared to most companies and that its return on assets was far higher than that of most insurance companies which had far lower ROEs despite their much higher leverage. This operation differed from most other insurance companies in at least three major ways: Financial leverage including debt and insurance float was and is unusually low and the common equity ratio unusually high.

Investments were and are concentrated in equities and even the ownership of entire businesses rather than in bonds. The insurance operation was and is unusually profitable or had unusually small losses even before considering profits from investments. This excludes the railroad and utilities segments as well as the finance segment. Those two excluded segments do use a lot of debt leverage. The rail and utility sectors are more recent additions to Berkshire and are excluded because they do not reflect its core insurance and investing operation.

The finance sector is excluded because it also does not reflect the core operation and is, in any case, quite small. Some notable characteristics of this condensed balance sheet include: The following is the full consolidated balance sheet from the end of on a percentage basis: Debt was very low, similar to On the asset side of the balance sheet, there was a significant allocation to cash.

The allocation to fixed maturity investments bonds was quite low. Almost three quarters of the assets were invested in equities. In part this is because the equities were marked to market while business assets were not. The percentage of assets devoted to subsidiary businesses and goodwill were much lower than in To be concise; Buffett entered the insurance business and achieved negative cost float through wise management and discipline and invested the float extremely wisely in high returning stocks and businesses and retained all earnings to grow the insurance, investment and business assets.

The material above documented the level of success achieved and has demonstrated that it was achieved by earning unusually high returns on assets accompanied by some use of unusually low-cost insurance float and zero-cost deferred tax leverage and by a very modest amount of debt leverage.

Setting a growth per share goal and sticking to it. He has never wavered from this goal and this measuring stick.

Relentlessly doing what was good for shareholders. Buffett always acted according to what was good and rational for shareholders. Investments that would reduce reported earnings temporarily were pursued if they made sense in the longer term. A dividend would have been popular but was not introduced because it would ultimately diminish shareholder wealth.

Growth was never pursued for the sake of growth if it would hurt shareholder wealth. A high level of equity and low debt and ample cash in the insurance companies allowed investing in equities. Most insurance companies invest primarily in bonds rather than equities. This reduces the risk of earnings volatility but also reduces long-term returns. Buffett very much targeted equities. By initially funding his insurance companies with high levels of equity and little or no debt and by then retaining all or substantially all insurance and investment earnings within the insurance companies he always had equity levels that were multiples larger than the minimums required by insurance regulators.

It appears that debt was totally avoided in the insurance operations. The modest debt shown in the balance sheets above is likely associated with its non-insurance subsidiaries and in the balance sheet its finance operations. Since financial risk amplifies the risks associated with assets, the lower level of financial leverage or financial risk allowed higher risks on the investment side including a heavy allocation to equities.

By maintaining a high cash level Buffett was never forced to sell investments at inopportune times in order to fund, for example, an unexpectedly high level of insurance payouts. Equities are perceived by regulators as higher risk, though Buffett did not see his stock selections as risky. Finding High Return Investments for the retained earnings.

The following contributed to accumulation of high-return assets. Superior Stock Picking —. It is well-recognized that Buffett exhibited superior stock picks skills. He bought wonderful businesses at fair or better prices rather than fair businesses at wonderful prices. Superior Business Acquisition Strategies.

It is clear that Buffett made many extremely successful business acquisitions. Rarely Issuing Shares for Acquisitions. Buffett has explained that, given that Berkshire itself was growing its net worth per share rapidly it was rarely ever the case that the shares were under-valued in the market. It almost always made sense to acquire for cash rather than shares. Through some combination of choosing the best managers and providing the right working environment and incentives and rewards both financial and emotional — as in public praise , Buffett was able to get extraordinary performance out of most of his subsidiary companies most of the time.

Becoming the Buyer of Choice. This led to some excellent acquisitions more or less falling into his lap and led to good prices for those acquisitions. Achieving profit on insurance operations. Buffett has often explained how most insurance companies do not make an operating or underwriting profit on their insurance operations before considering the profit on investments. In contrast, Berkshire managed to make a profit most years on its insurance operations even before considering the profits from investing the insurance float.

The use of Insurance float and deferred taxes to fund assets. Buffett has explained that using insurance float to fund investment assets can be very beneficial but only if the insurance companies operate with a cost of float that is lower than the cost of using debt.

Most insurance companies lose money on their insurance operations but make a profit overall by investing their insurance float. Most insurance companies face a high cost of float, usually not consistently lower, if any, than the cost of debt.

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