The Invisible Hand Behind Buffett's Magical Returns

In this issue:

» The poor track record of Corporate Debt Restructuring

» Can the Google IPO framework define Indian IPO market

» ...and more!

If you sort Warren Buffett's businesses by sector, insurance companies would occupy a good portion of the list. These are private businesses we're talking about, not the listed entities.

Also sample this...

In a CNBC interview three years back, Becky Quick, the CNBC correspondent, asked Warren Buffett the following question: 'If you could keep one company that Berkshire owns, either a wholly owned subsidiary, or that Berkshire owns a common equity in, which one would you keep and why?'

'I would keep GEICO,' pat came the reply.

As per Buffett, the stock changed his life. If he hadn't gone to the GEICO headquarters when he was still a budding investor and had a fellow there not kindly explained the insurance business to him, his life would have been vastly different.

What explains Buffett's fetish for insurance companies? He's clearly enamored by them.

The most compelling reason was cited in Buffett's Alpha, a 2012 academic paper that tried to break down Berkshire Hathaway's returns over the years.

Now, we all know Buffett's stock-picking skills are absolutely first rate. His knowledge, discipline, and longevity are all legendary. And his eye for cheap, quality, and stable stocks has turned Berkshire Hathaway into the best performing US company.

However, as per the paper, Berkshire's returns wouldn't have been so spectacular had it not been for two often overlooked factors: leverage and a judicious use of insurance float.

While the first factor is self-explanatory, the second needs some explaining.

We think Buffett figured out pretty early that the funds an insurance company takes from its policy holders lie on its balance sheet free of cost till the time they are not paid out as claims.

And these are revolving funds mind you. As claims are paid out, new premiums come in. As a result, Buffett always has at his disposal a good amount of capital that costs virtually nothing.

This is the double bonanza the academic paper highlighted. Think of it this way. A company's profitability is driven by three factors: what its assets earn, what its liabilities cost, and its use of leverage.

Buffett not only maximises what his assets earn; he minimises his cost of funds by making as much use of insurance float as possible. To top it off, he employs a reasonable amount of leverage.

Little wonder his returns have outperformed every company and mutual fund in existence for more than 30 years.

Now, given how the float of an insurance company has helped Buffett better his returns, wouldn't insurance companies make for great investment candidates?

They certainly would. Provided they aren't overpriced and don't incur huge losses while writing policies.

Well, this small crash course on insurance companies, the invisible hand behind Buffett's great returns, is just in time for the biggest insurance IPO to ever hit the Indian markets. ICICI Prudential Life Insurance Company Ltd is set to go public in just a couple of days.

Is ICICI Prudential making judicious use of its float? Is it earning great returns and reporting underwriting profits? Above all, is it sensibly priced? For answers to these questions and more, do watch out for our detailed review here.

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02:45 Chart of the day

The Corporate Debt Restructuring (CDR) mechanism was introduced way back in 2001 to deal with the menace of bad loans in the banking system. Under the CDR scheme, banks waive off the interest component or restructure interest rate downwards to aid defaulting corporate borrowers in loan repayment. But the scheme has not been very successful so far. This is reflected in the growing failure rate essentially measured in terms of the number of failed CDR cases as a percentage share of the total approved cases.

Of the overall 530 cases approved since inception, 228 cases have already failed at the end of June 2016. This translates into a failure rate of 43% that has steadily risen from 24% around three years ago. Till date, only 94 cases with debt worth Rs 688.9 billion have successfully exited the CDR cell whereas a whopping 25% of the Rs 4 trillion of total loans approved for restructuring have failed. One of the key reason why CDR has remained ineffective is the short tenure of restructuring that fails to match up with the longer development life cycle of infrastructure projects.

Even banks have not restructured fresh loans since 31^st March 2015 as the revised RBI provisions require them to provide for restructured loans at par with non-performing loans. Moreover, with the introduction of better schemes such as Strategic Debt Restructuring and Sustainable Structuring of Stressed Assets, CDR scheme is bound to get a further beating. However, it remains to be seen whether the improved restructuring measures can enable banks tide the stressed loan crisis that presently stands at 12% of the loan book.

Corporate Debt Restructuring not an effective tool

It is the season of big bang IPOs. Right from insurance companies, stock exchanges to infrastructure investment trusts and housing finance companies are queuing up with their issues to catch a piece of the market action. And the present exuberance in the markets is seeing investors lapping it all. However, one of the biggest risks in any IPO is the transparency in the IPO price discovery mechanism. The IPO price is arrived at by the issuer and the investment bankers. But given the buoyant market conditions, issuers invariably have an upper hand. This increases the possibility of IPOs being priced exorbitantly, mostly at the upper price band, and raises the level of risk for investors post listing.

One solution to bring transparency in the IPO pricing is an exchange-based system where the issue opens and closes on the same day and is monitored online by the regulator to clamp down on any manipulations. In fact, the first fair price discovery measure was successfully implemented more than a decade ago in the case of Google IPO of 2004. During the IPO, the Dutch auction method was applied wherein the auction starts from the high asking price and is reduced till a buyer is found. As a result of this mechanism, the Google IPO went on to become one of the most successful IPOs of all times generating spectacular returns of over 1,000% for investors who held on to the stock. And with the Indian equity markets in the thick of the IPO season, a similar regulatory framework will go a long way in making the IPO process fair and transparent for the small investors.

After opening the day on a strong note, Indian equity markets continued to surge. At the time of writing, BSE Sensex was trading higher by 307 points and NSE-Nifty was trading up by 87 points. Each of the mid cap and small cap indices were trading higher by around 1% each.

"I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst) and Madhu Gupta (Research Analyst).