How Warren Buffett Uses Taxes and Leverage to Boost Returns
- By Rupert Hargreaves
A good wealth management strategy looks at all areas of a company's or an individual's finances. There's far more to managing wealth than just concentrating on investments.
Investments are just one pillar of a good strategy. For example, a good wealth management strategy for an individual can also include analysis of discretionary spending, living costs, retirement assets, tax and estate planning.
Investors can achieve improvements in results by focusing on any one of these pillars, but the best results can only be achieved by using all of them as a package.
Warren Buffett (Trades, Portfolio) uses exactly the same approach at Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B). As well as focusing on the company's investments, he's also laser-focused on keeping costs low and maximizing tax benefits.
In the early days, it was reported that every manager of a Berkshire subsidiary had to call the Oracle of Omaha if they want to spend a significant amount on capital projects. Considering the size of the group today, this may be more difficult. Nevertheless, it shows the level of control the Oracle used to exercise over his business empire.
Buffett and leverage
Buffett has also become adept at maximizing Berkshire's profits by using leverage. I'm not talking about leverage in the traditional sense. Berkshire has never really borrowed a significant amount of money to invest. However, the company does effectively borrow money from its insurance clients.
These clients pay Berkshire a premium upfront to insure against certain risks. For example, Berkshire may provide $100 million of reinsurance to a company over a 12-month contract for a $10 million premium.
Technically, Berkshire is liable for $100 million, and it will have to pay that money out if required. But in the meantime, it can invest that $10 million. If the company does not have to pay out, that $10 million essentially becomes an interest-free loan. That's the simplified version, and of course the company needs to keep a suitable portion of its float quickly accessible in case payouts need to be made.
Buffett is also a master of leverage when it comes to taxes. Berkshire defers taxes in two ways. Firstly, Buffett rarely sells his investments. To give an example of how this benefits Berkshire, when Buffett bought Coca-Coca (NYSE:KO) in the late 1980s, he paid around $1.5 billion. Today it is worth around $22 billion. If he were to sell today, at the headline corporate tax rate of 21% in the U.S., Berkshire would pay $4.3 billion in taxes. Buying and selling multiple times would multiply the taxes paid.
Berkshire's second method to reduce its tax bill is through investments in depreciating assets such as power plants and rail infrastructure.
Buffett has also used asset swap deals in the past to reduce the group's tax bill, though this isn't as common. In 2014, for example, Berkshire agreed to exchange its $4.7 billion holdings of Procter & Gamble (NYSE:PG) shares for the P&G subsidiary Duracell. Tax on the capital gain will not be paid until Berkshire sells Duracell, which it is unlikely to do. The gain was around $4 billion. The swap deferred a potential tax liability of as much as $1 billion.
Every trick available
These deals show us that Buffett is an incredibly shrewd businessman, and over the years, he has made use of every available trick in the book to maximize returns. Investors can learn a lot from this approach.
Buffett has built the fortune he has today by maximizing returns wherever he can. This is a strategy every investor can and should use.
If there's a simple trick one can use to maximize returns, whether it be holding on to an investment for several decades to avoid capital gains, or acquiring tax-deductible assets, it is worth investigating.
The stock market is an unpredictable beast, and investors cannot control the market. However, we can use plenty of other strategies to maximize returns without relying on the market.
Disclosure: The author owns no share mentioned.
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This article first appeared on GuruFocus.
