Warren Buffett Hasn't Beaten the Market in Years -- Here's What Could Get Him Back on Track

Warren Buffett may be the greatest investor of all time, but his recent performance has been lackluster. Berkshire Hathaway's (NYSE: BRK-A)(NYSE: BRK-B) book value -- the basis by which Buffett largely gauges his performance -- has compounded at a rate less than the S&P 500 for five consecutive rolling five-year periods.

Buffett may be down, but he's not out. Here's one way Berkshire Hathaway can get back to beating the market.

How Buffett can get back on track

At the annual shareholders meeting last year, Buffett said that Berkshire was unlikely to compound at 10% per year -- roughly the historical return of the S&P 500 -- unless interest rates increased substantially.

We often think of Berkshire Hathaway as being a combination of operating businesses (See's Candies, BNSF, and Precision Castparts, for example) and common stocks it owns on the side. But the one thing that really makes Berkshire Hathaway, well, Berkshire, is its ability to use other people's money from its insurance units to generate investment returns.

Insurers take in premiums and pay out losses. But the time between taking in money and paying it back out results in what Buffett calls "float," or money that can be invested for Berkshire's benefit. When interest rates are higher, Berkshire earns a higher return on its float, boosting its earnings power. And because Berkshire has historically generated underwriting profits from insurance, the insurers effectively act as a mechanism to borrow money and get paid to do it.

A growing pile of borrowed money

Over the last 19 years, Berkshire Hathaway's float has grown at an average annual rate of about 8.8% per year. Last year was an anomaly, as Berkshire's float grew by more than 25% due primarily to a one-off deal with AIG, which Buffett called the largest-ever insurance policy in his letter to shareholders.

Money is fungible, so we can't say that Berkshire's float is invested in one asset or another. But it's worth pointing out that Berkshire's float at the end of 2017 (about $114 billion) approximated the amount of cash ($116.4 billion) that the company had on its balance sheet.

With one-year U.S. treasuries yielding about 2%, Berkshire stands to earn a pittance on its cash. Its $116 billion of uninvested cash would earn about $2.3 billion at a 2% interest rate, before taxes. As interest rates rise, however, the amount Berkshire earns on its cash, and thus its float, will only increase.

Berkshire's insurance edge

Buffett is obviously on the hunt for a major acquisition to deploy his holding company's cash, but even if he can't find a company worth acquiring, Berkshire should continue to benefit from rising rates earned on its cash and insurance float.

One way to quantify Berkshire's insurance edge is to compare its cost of float (what it earns or loses from insurance underwriting) to the average yield on one-year U.S. Treasuries. For example, Berkshire lost $3.2 billion from underwriting and had average float of $103 billion last year, thus its pre-tax "cost of float" was about 3.2%.

In other words, last year Berkshire effectively paid about 3.2% to "borrow" an average of $103 billion. On average, U.S. Treasuries yielded about 1.2% in 2017, so it paid about 2 percentage points more to borrow money through its insurance companies' float than the U.S. government paid to borrow money.

In most years, Berkshire has earned an underwriting profit, even when interest rates were much higher than they are today. In 2006, for example, Berkshire's cost of float was negative 7.7%, even though U.S. Treasuries yielded about 5% at the time. Thus, Berkshire would earn a "spread" of about 13% on its float that year, assuming it simply kept the float in one-year U.S. Treasuries.

While I expect most insurance companies to pass on the benefits of higher interest rates to their customers in the form of lower premiums, it's my view that Berkshire has a real edge in insurance, which should enable it to capture much of the upside from rising rates for the benefit of its shareholders. Berkshire's underwriting record is easily among the best in the insurance industry, helped by scale in reinsurance, and a cost advantage in consumer policies like auto insurance.

For this reason, rising interest rates appear to be the most likely lever to push Berkshire back in the black against the S&P 500. Unfortunately, it's the only thing that is completely out of Buffett's control.

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Jordan Wathen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.