Note: This post is a continuation of a previous post titled “Flirting with Floats: Part I.”
While cheaper-than-free float provided by astute insurance underwriting is the kind of float Buffett loves the most, there are other floats he has “flirted” with during the course of his long career.
Perhaps it started with American Express.
The American Express “Don’t Leave Home Without Them” Float Story
Between 1964 and 1966, Warren Buffett bet 40% of his partnership’s capital on American Express’ (Amex) stock, which had been battered down by the company’s involvement in the then infamous Salad Oil Scandal. Buffett’s investment of $13 million gave his partnership a 5% stake in the company, implying a total market cap of about $260 million at that time.
I searched for and found out Amex’s annual report for 1964. I urge you to read it. Apart from the fact that both its main businesses (travelers’ checks and credit cards) were doing extremely well, you will notice three additional points by studying its balance sheet on page 27: (1) The presence of $263 million of cash; (2) absence of interest-bearing debt; and (3) Travelers’ checks outstanding totaling to $525 million (a liability).
Those $525 million travelers’ checks represent float. People pay for travelers’ checks upfront and cash them later. The lag between purchase and their subsequent cashing may last a few days or even a few years (and sometimes they never get cashed). In the meantime, Amex gets to use the float for its business – free funds which otherwise it would have had to pay for.
Even though the Salad Oil Scandal had decimated the company’s stock price, as it did not have any interest-bearing debt, and had substantial cash to pay for the losses arising out of the scandal, all that Buffett needed to examine was the probability of it’s float disappearing. That, of course, would have happened only if the millions of holders of Amex’s travelers’ checks lost the trust behind the “American Express” brand.
In Buffett’s biography, “Snowball,” the author, Alice Schroeder, writes:
“The company’s value was its brand name. American Express sold trust. Had the taint to its reputation so leaked into customers’ consciousness that they no longer trusted the name? Buffett started dropping in on Omaha restaurants and visiting places that took American Express cards and Travelers Cheques. He put Henry Brandt on the case. Brandt scouted Travelers Cheque users, bank tellers, bank officers, restaurants, hotels, and credit-card holders to gauge how American Express was doing versus its competitors, and whether use of American Express Travelers Cheques and cards had dropped off. Back came the usual foot-high stack of material. Buffett’s verdict after sorting through it was that customers were still happy to be associated with the name American Express. The tarnish on Wall Street had not spread to Main Street.”
Despite the scandal, Buffett had figured out that Amex’s float was not going away. Without mentioning the investment, he hinted to his partners what he had done, by writing:
“We might invest up to forty percent of our net worth in a single security under conditions coupling an extremely high probability that our facts and our reasoning are correct with a very low probability that anything could drastically change the underlying value of the investment.”
I would speculate that if, instead of $525 million of cost-less float given to Amex by millions of its customers, American Express had $525 million of bank debt, Buffett would have stayed away from the stock. Bankers, he would have reasoned, could have easily recalled their loans from the scandal-ridden company resulting in a death spiral. But all of the customers holding travelers’ checks wouldn’t line up outside the company’s offices to cash them all. For them, the scandal was a non-event.
Buffett was right. Amex’s stock price trebled within the next two years as Wall Street slowly figured out what Buffett already had.
There is an important lesson about floats from the examples of Blue Chip Stamps and Amex: Float provided by millions of small customers can be quite enduring.
Amex’s float is similar to that enjoyed by banks on funds of customers they get to keep for free. Bankers are known to fight each other over floats represented by “non interest bearing current accounts” of large corporate customers. Free money, even for just a few days is worth fighting for, isn’t it? And then, of course, there is the case of very large sums of unclaimed deposits lying with India’s public sector banks. That’s float too.
What’s fascinating is how Amex’s float on travelers’s checks – something that attracted Buffett to the stock- became almost inconsequential over time, even though its dollar amount soared. As of the end of 1964, Amex had a total of about $525 million worth of Travelers’ checks outstanding, or 445% of its $118 million revenue for that year. That’s a big number. By the end of 2011, the company’s revenues had soared to $25 billion, while total travelers’ checks outstanding as of that year’s close were $5 billion, or just 20% of revenues. Paradoxically, the company’s credit and charge card businesses overtook the traveler’s checks business, which is now in terminal decline. Even so, Amex marched on and its the tag line for its travelers’ checks commercials (“Don’t leave home without them”) was altered to suit the commercials for its charge card. The new tag line became: “Don’t leave home without it.”
By 1968, Buffett sold out his 5% stake, which cost him $13 million for about $33 million. Many years later, he got back in the stock. By the end of 2004, Berkshire had bought a 10% stake costing it $1.4 billion. (That’s a good example of opportunity cost!).
The big problem for Buffett with Amex’s float was that he could only get a passive stake in it by buying his 5% stake. He could never control it.
All of that that changed when he, along with his friends bought Blue Chip Stamps.
The Blue Chip Stamps’ Float Story
In her excellent book, “Damn Right!: Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger,” the author, Janet Lowe, relates the 1967 story:
“An early precursor to frequent flyer miles in the 1950s and 1960s, trading stamps, such as Green Stamps, Blue and Gold, and Blue Chip, were handed out as a customer incentive by merchants. Retailers deposited money at Blue Chip in return for their stamps, then the money was used to operate the stamp company and to purchase the merchandise handed out when stamps were redeemed. Shoppers were given a certain number of stamps for each dollar spent in a store, which they pasted into books, then redeemed for prizes such as toddler toys, toasters, mixing howls, watches, and other items. Because it took time to accumulate enough stamps to redeem merchandise-and because some customers tossed the stamps in the back of a drawer, forgot them, and never did redeem them-the float built up.”
Lowe explains how Buffett ended up buying into Blue Chip:
“Charlie and I talked a lot about investment ideas,” said Rick Guerin. “I’d react about Blue Chip Stamps in the newspaper, and I had an idea,” Charlie said, ‘I’ll take you to my friend who knows more about float than anyone.’” When Guerin was introduced to Warren Buffett, Rick realized, as he had when he first met Munger, that he was talking to someone exceptional. Rick was pleased when Buffett immediately saw the same potential value of Blue Chip’s float that he had seen. Just by investing the float alone, the company could amount to something. Buffett, Munger, and Guerin slowly began accumulating shares, with Buffett buying the stock both for his personal account and for the Buffett Partnership.”
I couldn’t help but notice one of the comments in this video:
“Thank you so much for posting this. My mother died about a year ago and in one of her cookie jars I found a stash of S&H green stamps. She never redeemed enough for so much as a plastic pitcher, but it was always fun saving them up. Ah, memories.”
The green stamp capitalist would respond with nostalgia: “Ah, Float.”
There’s a fascinating aspect to the Blue Chip story. The company, which was later merged into Berkshire, acquired See’s Candy for $25 million in 1972 at a time when See’s total capital employed was $8 million. Revenues for that year were $30 million and pre-tax earnings were less than $ 5million. By 2007, as Buffett proudly noted in his letter for that year’s performance, See’s revenues had grown to $383 million, and pre-tax earnings were $82 million and yet the capital employed to run that business was just $40 million.
This means, wrote Buffett, “we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us.”
Buffett used Blue’s Chip’s float to acquire See’s and See’s float (as I shall explain later) to buy more businesses. He discovered that an enduring but free float, is a financial fountain that keeps pouring out cash.
But the really big (after insurance) attractive float that Buffett found, was given to him by the U.S. Treasury.
The Deferred Taxes Float Story
Berkshire owns marketable securities having market values far in excess of their acquisition prices. Taxes on gains realized on sale are payable only after the sale is made. If Buffett was to sell these securities, Berkshire would have to pay a very large tax bill. However, if he refuses to sell, and their market values continues to rise over time, then taxes not-due-but-which-would-have-been-due-if-he-had-sold-today would still need to be estimated and recorded as “deferred taxes” on Berkshire’s balance sheet. As of end 2011, these liability totaled to a staggering $ 38 billion.
For Berkshire, this $38 billion is also a form of float – functional equivalent to an interest-free loan from the U.S. Treasury. Buffett explained this power of delayed taxes by giving a wonderful example in his 1989 letter:
“Imagine that Berkshire had only $1, which we put in a security that doubled by yearend and was then sold. Imagine further that we used the after-tax proceeds to repeat this process in each of the next 19 years, scoring a double each time. At the end of the 20 years, the 34% capital gains tax that we would have paid on the profits from each sale would have delivered about $13,000 to the government and we would be left with about $25,250. Not bad. If, however, we made a single fantastic investment that itself doubled 20 times during the 20 years, our dollar would grow to $1,048,576. Were we then to cash out, we would pay a 34% tax of roughly $356,500 and be left with about $692,000. The sole reason for this staggering difference in results would be the timing of tax payments.”
Is this “float” which appears as a liability on Berkshire’s balance sheet really worth its value as calculated by accountants? No, it isn’t. Just as was the case with insurance float, where fair value of the liability was much lower than its book value, Buffett explained:
“We would owe taxes of more than $1.1 billion were we to sell all of our securities at year-end market values. Is this $1.1 billion liability equal, or even similar, to a $1.1 billion liability payable to a trade creditor 15 days after the end of the year? Obviously not – despite the fact that both items have exactly the same effect on audited net worth, reducing it by $1.1 billion.
On the other hand, is this liability for deferred taxes a meaningless accounting fiction because its payment can be triggered only by the sale of stocks that, in very large part, we have no intention of selling? Again, the answer is no.
In economic terms, the liability resembles an interest-free loan from the U.S. Treasury that comes due only at our election…”
To summarize, neither the insurance float, nor the float represented by deferred taxes on the liability side of Berkshire’s balance sheet are worth their book values. In his “Owner’s Manual” Buffett explains this again:
“Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets than our equity capital alone would permit: deferred taxes and “float,” the funds of others that our insurance business holds because it receives premiums before needing to pay out losses. Both of these funding sources have grown rapidly and now total about $100 billion.
Better yet, this funding to date has often been cost-free. Deferred tax liabilities bear no interest. And as long as we can break even in our insurance underwriting the cost of the float developed from that operation is zero. Neither item, of course, is equity; these are real liabilities. But they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of debt – an ability to have more assets working for us – but saddle us with none of its drawbacks.”
As of the end of 2011, Berkshire’s balance sheet carries assets having an aggregate book value of $392 billion. About $100 billion of these assets have been financed by the best form of OPM which either costs Berkshire nothing (deferred taxes), or it pays Berkshire for having it (insurance float)!
For me, it’s very instructive to observe how Buffett has flirted with various kinds of floats throughout his career. The seductive appeal of free (or less-than-free) money is all too alluring. He explained the logic in his 1995 letter:
“Any company’s level of profitability is determined by three items: (1) what its assets earn; (2) what its liabilities cost; and (3) its utilization of “leverage” – that is, the degree to which its assets are funded by liabilities rather than by equity. Over the years, we have done well on Point 1, having produced high returns on our assets. But we have also benefitted greatly – to a degree that is not generally well-understood – because our liabilities have cost us very little. An important reason for this low cost is that we have obtained float on very advantageous terms.“
Buffett hasn’t stopped looking for attractive floats. He once denounced derivatives as “financial weapons of mass destruction” but when he became aware that some of the esoteric derivative contracts could be a source of attractive float, he embraced them.
The Derivatives Float Story
In his 2008 letter, Buffett disclosed that Berkshire was a party to 251 derivative contracts consisting of equity puts, credit default swaps, and others. Describing these contracts, Buffett noted:
“As of yearend, the payments made to us less losses we have paid – our derivatives “float,” so to speak – totaled $8.1 billion. This float is similar to insurance float: If we break even on an underlying transaction, we will have enjoyed the use of free money for a long time. Our expectation, though it is far from a sure thing, is that we will do better than break even and that the substantial investment income we earn on the funds will be frosting on the cake.”
Aha! We get to see the same combination we saw in Berkshire’s insurance float – an underwriting profit (implying less-than-free float), and freedom to invest that float in buying undervalued assets.
In his 2010 letter, Buffett again emphasized these points:
“The thought processes we employ in these derivatives transactions are identical to those we use in our insurance business. You should also understand that we get paid up-front when we enter into the contracts and therefore run no counterparty risk.”
“In aggregate, we received premiums of $3.4 billion for these contracts. When I originally told you in our 2007 Annual Report about them, I said that I expected the contracts would deliver us an “underwriting profit,” meaning that our losses would be less than the premiums we received. In addition, I said we would benefit from the use of float…”
“It appears almost certain that we will earn an underwriting profit as we originally anticipated. In addition, we have had the use of interest-free float that averaged about $2 billion over the life of the contracts. In short, we charged the right premium, and that protected us when business conditions turned terrible three years ago…”
“What is sure is that we will have the use of our remaining “float” of $4.2 billion for an average of about 10 more years. (Neither this float nor that arising from the high-yield contracts is included in the insurance float figure of $66 billion.) Since money is fungible, think of a portion of these funds as contributing to the purchase of BNSF.”
Money is fungible, says Buffett. As I described in Part I, if Buffett can figure out a way to borrow money for free or even less than that, and if he can get to keep that money for a long long time without putting up collateral, then the fair value of those liabilities on Berkshire’s balance sheet are far below their book values. Under those conditions, as Buffett himself put it in his 2007 letter, “our investments can be viewed as an unencumbered source of value for Berkshire shareholders.”
Attractive floats, then, are “unencumbered sources of value” for shareholders of companies which get to enjoy them.
Are there other business models which have access to cheap floats? Yes indeed, there are, and they go by the name of “moats.”
You see, Floats and Moats go together. That’s the subject matter of a subsequent post.
To be concluded…
15 thoughts on “Flirting with Floats: Part II”
Fantastic post. Have always loved the See’s story because that is a true wonderful business which has always spewed out valuable cash for the holdco. I believe that people often overlook cash flow to shareholders in favour of PAT or cash from operations, while judging investments.
Great story Prof, had posted a small analysis of Sees Candy a few months ago
Thanks sir. I guess one the key reasons for Mr. Buffett’s early success has been the recognition of the fact that cash in books/float can be used to his advantage/strength (capital allocation), either in those business which are under structural decline or are facing temporary setbacks (which gave him the opportunity to buy the business at significant margin of safety to his conservatively determined value). Some examples of former are Sanborn Map & Dempster mills from Buffett’s early partnership in early 1960s, Blue Chip stamps in 1970s through Berkshire Hathaway/personal holdings; key examples of latter are GEICO/Amex.
This is what Mr. Buffett wrote on Dempster mills in 1963 letter to partners, “…We obtained control in August, 1961 at an average price of about $28 per share, having bought some stock as low as $16 in earlier years, but the vast majority in an offer of $30.25 in August. When control of a company is obtained, obviously what then becomes all-important is the value of assets, not the market quotation for a piece of paper (stock certificate)…… Three facts stand out: (1) Although net worth has been reduced somewhat by the housecleaning and writedowns ($550,000 was written out of inventory; fixed assets overall brought more than book value), we have converted assets to cash at a rate far superior to that implied in our year-earlier valuation. (2) To some extent, we have converted the assets from the manufacturing business which has been a poor business, to a business which we think is a good business –securities. (3) By buying assets at a bargain price, we don’t need to pull any rabbits out of a hat to get extremely good percentage gains. This is the cornerstone of our investment philosophy: “Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. The better sales will be the frosting on the cake.”……………………. On January 2, 1963, Dempster received an unsecured term loan of $1,250,000. These funds, together with the funds all ready “freed-up” will enable us to have a security portfolio of about $35 per share at Dempster, or considerably more than we paid for the whole company. Thus our present valuation will involve a net of about $16 per share in the manufacturing operation and $35 in a security operation comparable to that of Buffett Partnership, Ltd……….”
Also re-read the chapter on Blue Chip stamps today, from Damn Right, post your post: “Tracing the story of Blue Chip Stamps from its inception to the present is confusing, but is central to understanding how Munger, Buffett, and Guerin became so rich, and how Berkshire Hathaway evolved into the company it is today. Blue Chips became the vehicle through which See’s candy, Buffalo News, and Wesco financials were acquired, and these three companies later became essential to the culture and financial foundation of Berkshire.”
Sir, thanks again for your post and please keep them coming regularly.
The post reminds me of the song Money for Nothing 🙂
People paying a company because of they trust it.
MTV paying Knopfler to play the guitar … and the chicks for free.
The company gets millions. Knopfler probably made some good money too 🙂
If only Sodexo was listed…. 🙂
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Apart from insurance companies in india…Are there any companies that make efficient use of their float ?
[…] Flirting with Floats: Part II […]
prof. having Little problem on deferred tax story.. how this accounting concept creates economical value ..
understood every thing else … derivatives.. insurance.. negative working capital with cash without debt… these are receive first give later. deferred tax looks a little different. please.
Not all floats arise from receipt of cash. Even in the case of negative working capital, there are two sources: Trade Credit, and Advance from Customers (deferred revenue). While advance from customers result in cash inflow, trade credit does not.
Trade credit require a future cash outflow, while advance from customers are satisfied by delivery of goods or services, which result in cash outflow lower than advance received, because the firm operates at a profit.
So, if you can understand trade credit as a source of float (which may or may not have a cost), then you can use the same logic to understand deferred taxes as a source of float. There is no cash inflow to create a float from deferred taxes. The float arises from the fact that if you were to realize capital gains by selling an asset, then taxes become due immediately, but if you simply hold on to the asset which keeps on appreciating, then taxes on unrealized gains which aren’t due, because you haven’t sold the asset, become the functional equivalent of an interest-free loan from the taxman.
In addition, see the following from Charlie Munger’s 2007 letter to Wesco’s shareholders:
Wesco carries its investments at fair value, with unrealized appreciation, after income tax effect, included as a separate component of shareholders’ equity, and related deferred taxes included in income taxes payable, on its consolidated balance sheet. As indicated in the accompanying financial statements, Wesco’s net worth, as accountants compute it under their conventions, increased to $2.53 billion ($356 per Wesco share) at yearend 2007 from $2.40 billion ($337 per Wesco share) at yearend 2006. The main causes of the increase were net operating income after deduction of dividends paid to shareholders, and appreciation in fair value of investments.
The foregoing $356-per-share book value approximates liquidation value assuming that all Wesco’s non-security assets would liquidate, after taxes, at book value. Of course, so long as Wesco does not liquidate, and does not sell any appreciated securities, it has, in effect, an interest-free “loan” from the government equal to its deferred income taxes of $322 million, subtracted in determining its net worth. This interest-free “loan” from the government is at this moment working for Wesco shareholders and amounted to about $45 per Wesco share at yearend 2007. However, some day, parts of the interest-free “loan” may be removed as securities are sold. Therefore, Wesco’s shareholders have no perpetual advantage creating value for them of $45 per Wesco share. Instead, the present value of Wesco’s shareholders’ advantage must logically be much lower than $45 per Wesco share.”
don’t know of any better way some one could have told about deferred tax liability ….. as a simple device you used no brainer example of Trade Credit . Many Many thanks !!
Wow! Amazing articles.
[…] with copies of the now-ancient annual reports — were just presented by some great blogs. See here for American Express in 1964/65, here for Coca-Cola in 1988, here for Dairy Queen in 1997, and here for Wal-Mart in […]
Hi, the file is no longer available – do you think you could post it on your site? Thanks
Hello excellent article.
Just a question about the Amex valuation/price paid by Buffett;
1964-65: WB paid 13 million for 5% stake, implying market value of260 million
Amex 1964 net income was 12,5 million (source: annual report)
So did Buffett pay a price/earnings ratio =260/12,5 of 20,8?
Seems very high, no?
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