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Berkshire Hathaway Is More Like a Bank Than You Think

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What is the defining characteristic of a bank? There are many different types of banks, but the thing that unites almost all of them is they borrow money from depositors and give it to lenders. In the industry parlance, banks "borrow short and lend long," meaning they take in deposits on a short-term basis and make long-term loans, like mortgages. They pay a lower interest rate to depositors than they make from the loans. The difference between those two numbers is known as the "net interest margin" - or the margin that the bank makes on its business. In short - they invest with borrowed money.

Now, when you think of Warren Buffett (Trades, Portfolio), you probably don't think of him as a banker. He is most widely known as a stock picker, adept at finding undervalued companies (or fairly valued ones with great growth potential) and reinvesting the cash generated by those businesses into more stocks. But in one important way, Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) has behaved like a bank - it invests with borrowed money.

How Berkshire is different

OK- you got me, Berkshire is not a bank. Berkshire Hathaway is a conglomerate that owns many different businesses, but its core business is insurance. Insurance is in some ways similar to banking: the insurer collects payments from customers, called premiums, and promises to pay out money when the customer suffers some adverse event (car accident, house burning down, death, etc.), called claims. While this process seems simple, there is a time delay between when the premiums are collected and when the claims are paid. A 45-year-old businessman may take out a life insurance policy and live for another 40 years.

The premiums that the insurance company holds on to is known as the float and, as illustrated by the above example, it can remain on the insurer's books for a long time. As you no doubt know, money that is just gathering dust is of no use to anyone, so insurance companies will invest the float. The typical insurer, fearing stock market volatility, will invest most of their float into bonds to lock in a low-risk, low rate of return stream of cash. However, Buffett realized pretty early on that insurance float could be better deployed by investing prudently in stocks.

Usually, the insurer will pay out more in claims than they collect in premiums (this is known as the "cost of float"), and will attempt to make that money back from their investments. By contrast, Berkshire's insurance business is so well-run that it actually makes a few percentage points of profit (it has a positive cost of float), and that's before the impressive return on invested capital that Berkshire makes from investing its float.

The point

Now both Buffett and Charlie Munger (Trades, Portfolio) are fond of talking about the perils of using leverage for investment purposes, but the reality is Berkshire was built on borrowed money. Now, obviously there is a difference between using insurance float as leverage and taking out a high-interest loan. I'm also not accusing the Berkshire pair of being disingenuous when they advise ordinary investors to stay away from debt (this is actually good advice), but there were plenty of insurance companies that attempted the same strategy in the 1980s and blew up when their cost of float was too great and their return on invested float was too small. Maybe then their advice should be amended to: "Don't invest with borrowed money unless your name is Warren Buffett or Charlie Munger."

Disclosure: The author owns no stocks mentioned.

Read more here:

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  • Joel Greenblatt: How to Handle the Emotional Aspects of Investing

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This article first appeared on GuruFocus.