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Warren Buffett's Secret Sauce

By Christopher Ruddy
Monday, 09 Jul 2007 03:07 PM Current | Bio | Archive

This past March 1 when Warren Buffett released his annual letter to shareholders of his Berkshire Hathaway, the major wire services reported on his company's success — a net worth gain of $16.9 billion in 2006, or 18.4 percent.

Press reports didn't bother to tell you about the real reasons behind Buffett and Berkshire's success.

NewsMax's sister publication, MoneyNews.com, did in a special report.

What makes Warren Buffett so successful?

Let me call it Warren's "secret sauce."

It really isn't a big secret. Buffett, the candid man he is, reveals his secret sauce right there on page 4 of his letter, in the last two seemingly innocuous paragraphs of that page.

Stock investors are often stunned by Berkshire's performance. The per-share book value of Berkshire has grown some 361,156 percent since 1965 — at a rate of 21.4 percent per year (compared to 6,479 percent growth or 10.4 percent annually for the S&P).

With such results, Buffett has been called the greatest stock investor of our time. But that description is not entirely accurate. Buffett is among the greatest investors in the world, but strike the word "stock" next to "investor."

As Buffett notes in what I'll call his secret sauce paragraphs from page 4 of his annual letter, his company made its biggest gains not from investing in stocks, but in buying companies outright and controlling them.

Buffett explains his secret sauce as follows:

"In our early years we put most of our retained earnings and insurance float into investments in marketable securities [stocks, bonds, etc.]. Because of this emphasis, and because the securities we purchased generally did well, our growth rate in investments was for a long time quite high."

"Over the years, however, we have focused more and more on the acquisition of operating businesses. Using our funds for these purchases has both slowed our growth in investments and accelerated our gains in pre-tax earnings from non-insurance businesses, the second yardstick we use."

In other words, Buffett is saying Berkshire makes its money not from stock investing but from actually acquiring and running companies.

Because he has been doing less investing in, as he puts it, "marketable securities," his earnings have increased.

Buffett reveals that because he does this his margins are much higher, but he adds that it is much more difficult to find good private companies.

For sure, Berkshire is not simply an investment vehicle, like a mutual fund, but a holding company that ultimately manages all sorts of subsidiary businesses.

Another important fact about Buffett's investment success: He's made a fortune in insurance.

In his most recent letter Buffett makes it clear that his insurance businesses have been his greatest winners. Last year alone his various insurance companies, most well known being GEICO, raked in more than $3.8 billion in underwriting profits.

Few of us can do what Buffett does — that is, own an insurance company. We can invest in any number of publicly traded insurance companies. But it is doubtful stock investors will see the type of returns Buffett generates from his companies.

Here's why: Buffett essentially acts as the private owner of his subsidiary companies. He doesn't draw a salary from his subsidiary companies. His profit comes from holding each subsidiary company and its management accountable for their successes and failures.

Since Buffett does not draw a salary from his subsidiary companies, and he makes a modest salary from his holding company Berkshire, Buffett reports when the value of his underlying stock increases — in tandem with all the other shareholders.

Buffett has a huge incentive to get as much profit from his companies so that it can be passed on to his holding company Berkshire Hathaway, and to him, Berkshire's largest shareholder.

Compare that situation to most public companies where the management does not directly benefit when shareholder's benefit.

In truth, I believe huge amounts of corporate earnings are eaten by fat and sloth. We see these excesses in corporate compensation schemes, huge stock option grants, and lulus like corporate jets that are often wasteful perks.

Add to the mix that large public companies typically have a diverse shareholder base, which selects boards really picked by management — boards that rubber stamp management and never demand full accountability.

As a rule, the so-called Blue Chip public companies not only fail to make great payouts to investors, ultimately they fail to use profits wisely to adapt and grow their underlining enterprises.

In his letter Buffett notes the reality of big public companies: "Here's a telling fact: Of the 10 non-oil companies having the largest market capitalization in 1965 — titans such as General Motors, Sears, DuPont, and Eastman Kodak — only one made the 2006 list."

More and more, the wisest and wealthiest investors are discovering the power of private investments over public equity markets.

Recently, Fortune magazine published a lengthy feature on "Private Money." Telling is the rise of private equity funds, which 15 years ago had total capitalization in the billions but just in single digits. Today, capital in private equity funds exceeds $150 billion. And those figures don't include the amount of money wealthy individuals invest privately without using such funds.

Indeed, the money is flowing into private investments because they tend to outperform public investments.

A recent study by the University of Massachusetts explained why private investments work so well: "Private equity is generally regarded as an investment which offers investors the opportunity to achieve superior long-term returns compared to traditional stock and bond investment vehicles. Private equity investments provide higher return opportunities relative to traditional asset classes primarily through their ability to participate in a vast and growing marketplace of privately held companies not available in traditional investor products."

But there are significant risks. For example, private investments often entail backing new and emerging companies.

As any businessperson knows, most new businesses fail, thus investors must be willing to lose all or most of their investment. But the winners in private investment can offer incredible, Buffett-style returns to investors.

Another problem with private investments is that often there is little or no liquidity. Simply, you may not be able to cash out, as there is no liquid market like that found in the stock market.

Still, more and more sophisticated investors, also described by the SEC as "accredited investors" — typically those having a net worth exceeding $1 million — have been placing some of their portfolio in such private investments.

Because of the growing interest in this area, we at MoneyNews.com and our print monthly Financial Intelligence Report have been covering the topic of private investing.

We offer revealing information on how to navigate the waters of private investing, and avoid some of the pitfalls. One of our first reports has dealt with the dangers of hedge fund investing.

As a NewsMax subscriber, you have to let us know you want to be a MoneyNews.com subscriber.

It's simple to do so, and also free!

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RuddyMN
This past March 1 when Warren Buffett released his annual letter to shareholders of his Berkshire Hathaway, the major wire services reported on his company's success a net worth gain of $16.9 billion in 2006, or 18.4 percent.Press reports didn't bother to tell you about...
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