Replicating Berkshire Hathaway's famous investing engine

Was the Woodstock of Capitalism ever meant to be this emotional? Last weekend, the Berkshire Hathaway (US:BRK.B) faithful assembled in Omaha for their first annual general meeting without Charlie Munger, the man its chief executive has hailed as the conglomerate’s ‘architect’.

At the gathering, Warren Buffett himself veered between present and past tense, accidentally referred to his anointed successor Greg Abel as “Charlie”, and ended with a joke whose characteristic self-deprecation and charm was full of poignancy. “I not only hope you come next year,” the world’s greatest and most famous investor told his audience. “I hope I come next year.”

Perhaps it was the spectre of Munger, or the weight of an occasion bookended by standing ovations, but the 93-year-old appeared palpably more fragile than he did 12 months ago.

But while Berkshire Hathaway without Buffett still seems an impossible notion, Buffett has done his best to build something that should long outlast him. For a start, and depending on your perspective, it either sits on a mountain of dry powder or a source of huge risk-free cash generation. The group’s first quarter ended with $182bn in cash and US Treasury bills, a figure Buffett expects to grow to $200bn by the half-year.

Home to a plethora of companies and stock holdings patiently acquired over many decades, its balance sheet is backed by more than $1tn of assets. Shareholder equity also stands at $571bn, a third below Berkshire’s market capitalisation of $874bn, and almost double the highest level among any of the Magnificent Seven stocks.

But the most critical strut in Berkshire’s frame cannot be conveyed in a familiar, apples-to-apples metric. It is what Buffett calls the group’s “float”: a colossal pool of insurance premiums, held to pay claims or invest, which constantly flow into Berkshire’s coffers via its ownership of multiple property and casualty insurers, including Geico, BH Reinsurance and Gen Re. In 1970, three years after Berkshire entered the sector with the purchase of National Indemnity and National Fire & Marine, the float stood at $39mn. Today, it is $168bn.

Long ago, Buffett cottoned onto the idea that, to the insurer, paid premiums are a kind of ultra-low-cost capital. But rather than divert this river of cash into high-grade corporate and government bonds (as most insurers are wont or compelled to) Buffett opted to funnel this money into what he saw to be the highest available return on capital. Historically, this meant the stock market, although these days it is just as likely to be cash and US T-bills.

In the first quarter of 2024, Berkshire earned $21.5bn in insurance premiums, against $13.4bn of losses and adjustment costs, and $3.8bn in underwriting costs. All told, this led to a $2.6bn underwriting profit for the period, which alongside $2.6bn of investment income amounted to another $5.2bn slug of capital to be recycled back into new insurance business, or the float.

Although this capital is both cheap (given insurers’ long-term incentive to profit through smart underwriting) and timely (because premiums are paid up-front, and claims paid later), liabilities are of course attached. So while Berkshire does not expect its float to decline by more than 3 per cent in any given year, it has to be sufficiently liquid to meet claims as they come due.

Given industry competition, it can be hard to imagine how premiums might be a cheap source of money. To see why – and even though much of the cash Berkshire holds for investment stems from complex and esoteric reinsurance contracts – consider the odds in favour of a life insurer.

First, there is a well-resourced underwriter’s informational advantage over a group of disparate policyholders who are often willing to pay up for peace of mind. Then there are changes to the claims environment, again far better understood (and priced) by the insurer, such as the frequently overlooked stalling in UK life expectancies since 2011. Third is the sub-optimal use of life insurance, either involving claims that could be made but aren’t, or lapsed policies. These aren’t things life insurers are in the habit of crowing about, but they matter to profits.

In short, while insurance profits are neither easily forecastable nor ever likely to grow faster than the market average, they are both real and provide an excellent stream of cash on hand.

Float-worthy?

Among Berkshire shareholders, the float is seen as the great hope for outperforming the S&P 500 index once Buffett’s halo effect is gone. Even with this cash machine, the conglomerate’s sheer size and industrial focus leaves it with limited room to consistently beat the market. Abel, who Buffett hinted would assume responsibility for both capital allocation and stock selection at last week’s AGM, will be acutely aware of this.

But given the average investor isn’t limited by such size concerns, it’s worth asking whether elements of the float can be deployed in a common-or-garden portfolio.

This might seem like a non-starter. After all, if you don’t own an insurance business outright, then you’re going to struggle to replicate Berkshire’s playbook. For those with access to a float-like cash pool – such as a small business’s working capital, or a cash register – it’s probably unwise to start treating it as equivalent.

However, there are ways to adapt the principle. One option is to automatically transfer any dividends or rainy-day cash into a higher-rate interest account, assuming of course that this income isn’t required for living expenses. Another is to work with the features of the insurance sector to build a series of income streams that are uncorrelated to the broader market, and which can be used as a source of capital for new investments.

One way to do this is to simply buy the shares of high-yielding insurers. By spreading the ‘float portfolio’ across several firms and different areas of the industry, single-stock risk declines. The table below shows eight UK firms that have continued to pay a dividend over the past two years, and whose trailing yield has averaged at least 3 per cent during the period.

Admittedly, those filters create a slightly rosier picture than some of the sector’s laggards might otherwise paint. Car insurer Direct Line (DLG) and Asia-focused life insurer Prudential (PRU), both of which have struggled for momentum, are notable by their absence. Then again, so is specialist insurer Beazley (BEZ), whose focus on the booming cyber market has helped it post a 61 per cent total return over the past two years.

But the returns and volatility have been acceptable. On balance, strong yields haven’t been a harbinger of capital losses, meaning UK-listed insurers have probably been undervalued. As such, and despite the seasonality of dividend payments, relying on these shares’ income to grow or recapitalise a float would have helped meet the needs of the stockpicker who doesn’t like to sell, but does like to regularly consider new options.

One criticism of this strategy is that for it to generate a useful amount of cash, it must cede too much of a portfolio to one sector. Better, you might argue, to just invest in stocks that offer the best opportunities for long-term growth, and therefore as a destination for reinvesting dividends. Remember that, if nothing else, Berkshire Hathaway serves as a lesson in the virtue of compounding.

Then again, perhaps Berkshire's armour-plated balance sheet would be that much stronger if it had put more of the float into growth equities in recent years. We can but ponder the trade-offs, whether it’s managing a Sipp, an Isa, or the most successful quasi-mutual fund in history.