by InvestingExplained
Today we’re going to talk about float, what it is and how you can build billion-dollar companies with it. Float is the money that a business receives today but doesn’t have to pay out until sometime in the future. Float is most commonly seen in insurance companies with customers paying premiums upfront to insure themselves against bad things happening sometime in the future. More examples include: Video game publishers, where they receive pre-orders. Commercial banking when they receive deposits and so on.
Why is receiving money upfront so valuable even when it needs to be paid at later date? Well, you can invest it! And the longer you have to invest it, the more likely it will grow larger than the amount that you will have to eventually pay out! So, you can see how easily this can snowball. Say I owned a tiny insurance business that insured $1,000 worth of damages for a year in exchange for a $100 upfront payment. If I have $10,000 in the bank I can safely have say, five customers insured like this every year for $500. Every year I can invest the money I got from those new customers and every year the cash I have grows so I can safely insure more customers and the cash you have grows in an exponential manner. Ok cool got it. So, what does this have to do with Berkshire Hathaway?
Sometime around the mid-1960s Mr. Buffett realized, with the help of his friend Charlie Munger, that he can’t keep investing in broken down businesses and had to instead look for “franchise” business that will continue to compound his hard earned capital through thick and thin. The next thing he realized is that he couldn’t just rely on the free cash flow generated from those company’s and had to instead find low cost financing for his acquisitions. That low cost financing came in the form of an insurance float which, as we’ve seen, are the premiums paid by insurance customers up front in order to be paid out by the insurance company later. Buffett bought a ton of these insurance companies starting with National Indemnity in 1967
Wait, why did we just say that float is low cost financing? Why is it financing and what is the cost of that financing? Well, float is financing because you are receiving money today, but you have to pay it out sometime in the future, exactly like a loan. The beauty of float though is that you don’t have to pay interest on that money! The only “interest” that you have to pay on that money is the normal cost of operating your business.
We’ve already seen why float would matter so much to Buffett, but it bears repeating. A dollar you receive today is worth more than a dollar you get a week from now because you can invest it at some rate to receive more money in the future. Buffet realized that the more float he had, the more float he could invest to buy other businesses. Float would compound in lockstep with the free-cashflow generated by his other businesses and in time create a juggernaut.
The final step in the Berkshire secret formula was increasing the duration of time between when the premiums are received and when they’re paid out. So, for Buffett, this meant buying up longer tailed insurance companies like insurance for catastrophes, and recently, Reinsurance companies. And there you have it! This is the basic DNA of one the most successful stocks in over the past 50 years and they’re still going at it.