Here’s the Secret Sauce Behind Berkshire Hathaway’s Long-Term Outperformance

From 1965 to 2021, Berkshire Hathaway (BRK.A -0.62%) (BRK.B -0.63%) delivered its investors a 3,641,613% return, or over 20% annually. You may believe its success is due to Warren Buffett’s investing prowess, but that’s only one part of the equation.

One crucial component of Berkshire’s success over the years is its cash. Berkshire Hathaway leads the world in cash it holds and invests, but which doesn’t actually belong to it. This giant pile of money allows the company to take a long-term outlook and invest in great companies with upstanding leaders and at reasonable prices. Understanding the dynamics of this puts its entire business into perspective.

How Berkshire Hathaway invests cash it doesn’t own

Berkshire Hathaway has access to $147 billion of other people’s money because of its insurance businesses.

Berkshire wholly owns several insurance businesses, including GEICO, General Re, Berkshire Hathaway Reinsurance, and National Indemnity. Cash flow for insurance companies is different from other businesses. Insurers collect premiums upfront before ever providing their service of resolving insurance claims. Because the cash doesn’t get paid out until a customer files a claim, insurers sit on a pile of money they can hold and invest but don’t actually own. This cash is called “float.” Buffett credits float for Berkshire’s stellar performance since it first purchased National Indemnity in 1967. To date, Berkshire’s float has grown from $19 million to $147 billion, or over 18% annually. 

Berkshire’s insurance businesses have delivered profits over its 55 years of owning them. Its cash flows are relatively reliable. Buffett told shareholders this year in his annual letter, “Funds attributable to our insurance operations come and go daily, but their aggregate total is immune from a precipitous decline.” For this reason, the float is considered “sticky,” or not changing too much, which allows Berkshire to take a long-term approach to its investments.

The most significant risk for Berkshire is if its insurance businesses see an underwriting loss of epic proportions or big persistent losses over several years. In that event, its float could drop, which could impact some of its long-term investments. However, Berkshire is currently flush with cash. That, and Buffett says, “Berkshire is constructed to handle catastrophic events as no other insurer — and that priority will remain long after Charlie and I are gone.” 

Insurance is a critical component of Berkshire Hathaway’s long-term success

Berkshire’s insurance businesses are the main cog that makes the business run. Warren Buffett and Charlie Munger have done a spectacular job of investing — but without that insurance float, Berkshire wouldn’t be the company it is today.

Berkshire Hathaway is one of the world’s largest insurance companies, but its investments have overshadowed the business. Owning insurance companies has worked for Buffett because of their float, but he has additional reasons for liking them. For Buffett, insurance is a “very large chunk of Berkshire’s value,” partly because insurance products “will never be obsolete, and sales volume will generally increase along with both economic growth and inflation.” 

What investors can learn from Warren Buffett’s love of insurance

As investors, we can take away a couple of things from this. One, Berkshire Hathaway is a stellar company you can buy and hold forever (as long as its insurance business runs smoothly). Second, insurance companies can make solid investments that deliver good returns with lower volatility. Outside of Berkshire Hathaway, some well-run insurers I like include Progressive, Aflac, Globe Life, Markel, and Kinsale Capital Group.

The insurance business will always have steady demand, and companies can produce extra returns by investing their float. In the current rising interest rate environment, insurers are in a perfect position to capitalize by investing in relatively safe assets at yields they haven’t seen in years. These businesses have also done a good job of monitoring inflation and adjusting accordingly — and now wouldn’t be a bad time to add some to your portfolio.

Courtney Carlsen has positions in Progressive. The Motley Fool has positions in and recommends Berkshire Hathaway, Kinsale Capital Group, and Markel. The Motley Fool recommends Aflac and Progressive and recommends the following options: long January 2023 $200 calls on Berkshire Hathaway, short January 2023 $200 puts on Berkshire Hathaway, and short January 2023 $265 calls on Berkshire Hathaway. The Motley Fool has a disclosure policy.