Warren Buffett's Secret Sauce

By Christopher Ruddy
 

Each year when Warren Buffett releases his annual letter to shareholders of Berkshire Hathaway, the major media pounce on it and a flurry of news reports hit the wires.

But these glowing press reports don't bother to tell you about the real reasons behind Buffett and Berkshire's accomplishments.

But what really makes Warren Buffett so successful?

Let me call it Warren's "Secret Sauce."

Stock investors are often stunned by Berkshire's performance. The per-share book value of Berkshire has grown some 361,156 percent since 1965 — at a rate of 21.4 percent per year (compared to 6,479 percent growth or 10.4 percent annually for the S&P).

With such results, Buffett has been called the greatest stock investor of our time. But that description is not entirely accurate. Buffett is among the greatest investors in the world, but strike the word "stock" next to "investor."

As Buffett notes in what I'll call his secret sauce paragraphs in his annual letter, his company made its biggest gains not from investing in stocks, but in buying companies outright and controlling them.

Buffett explains his secret sauce as follows:

"In our early years we put most of our retained earnings and insurance float into investments in marketable securities [stocks, bonds, etc.]. Because of this emphasis, and because the securities we purchased generally did well, our growth rate in investments was for a long time quite high."

"Over the years, however, we have focused more and more on the acquisition of operating businesses. Using our funds for these purchases has both slowed our growth in investments and accelerated our gains in pre-tax earnings from non-insurance businesses, the second yardstick we use."

In other words, Buffett is saying Berkshire makes its money not from stock investing but from actually acquiring and running companies.

Because he has been doing less investing in, as he puts it, "marketable securities," his earnings have increased.

Buffett reveals that because he does this his margins are much higher, but he adds that it is much more difficult to find good private companies.

For sure, Berkshire is not simply an investment vehicle, like a mutual fund, but a holding company that ultimately manages all sorts of subsidiary businesses.

Few of us can do what Buffett does — that is, own multiple companies. We can invest in any number of publicly traded companies, but it is doubtful stock investors will see the type of returns Buffett generates from his companies.

Here's why: Buffett essentially acts as the private owner of his subsidiary companies. He doesn't draw a salary from his subsidiary companies. His profit comes from holding each subsidiary company and its management accountable for their successes and failures.

Since Buffett does not draw a salary from his subsidiary companies, and he makes a modest salary from his holding company Berkshire, Buffett reports when the value of his underlying stock increases — in tandem with all the other shareholders.

Buffett has a huge incentive to get as much profit from his companies so that it can be passed on to his holding company Berkshire Hathaway, and to him, Berkshire's largest shareholder.

Compare that situation to most public companies where the management does not directly benefit when shareholders benefit.

In truth, I believe huge amounts of corporate earnings are eaten by fat and sloth. We see these excesses in corporate compensation schemes, huge stock option grants, and lulus like corporate jets that are often wasteful perks.

Add to the mix that large public companies typically have a diverse shareholder base, which selects boards really picked by management — boards that rubber stamp management and never demand full accountability.

As a rule, the so-called Blue Chip public companies not only fail to make great payouts to investors, ultimately they fail to use profits wisely to adapt and grow their underlining enterprises.

In a recent letter, Buffett notes the reality of big public companies: "Here's a telling fact: Of the 10 non-oil companies having the largest market capitalization in 1965 — titans such as General Motors, Sears, DuPont, and Eastman Kodak — only one made the 2006 list."

More and more, the wisest and wealthiest investors are discovering the power of private investments over public equity markets.

Recently, Fortune magazine published a lengthy feature on "Private Money." Telling is the rise of private equity funds, which 15 years ago had total capitalization in the billions but just in single digits. Today, capital in private equity funds exceeds $150 billion. And those figures don't include the amount of money wealthy individuals invest privately without using such funds.

Indeed, the money is flowing into private investments because they tend to outperform public investments.

A recent study by the University of Massachusetts explained why private investments work so well: "Private equity is generally regarded as an investment which offers investors the opportunity to achieve superior long-term returns compared to traditional stock and bond investment vehicles. Private equity investments provide higher return opportunities relative to traditional asset classes primarily through their ability to participate in a vast and growing marketplace of privately held companies not available in traditional investor products."

But there are significant risks. For example, private investments often entail backing new and emerging companies.

As any businessperson knows, most new businesses fail, thus investors must be willing to lose all or most of their investment. But the winners in private investment can offer incredible, Buffett-style returns to investors.

More and more sophisticated investors, also described by the SEC as "accredited investors" — typically those having a net worth exceeding $1 million — have been placing some of their portfolios in such private investments.

To open up our readers to these private investing opportunities, Newsmax and Moneynews have launched the "Private Opportunities Club" — a no fee membership organization that provides you with a newsletter, meetings, and other forums to find out how high net worth investors can seek maximum returns in private investments.

Our Club newsletter reveals important information on how to navigate the waters of private investing, and how avoid some of the pitfalls.

Our first edition dealt with the dangers of hedge fund investing and a recent version addresses solid asset management and high income opportunities available in turbulent market conditions.

We also plan on sharing private investment opportunities in new companies and other vehicles we feel are relevant to high net worth investors that you may want to participate in.

Again, joining the Club and receiving the new newsletter are FREE and available only to accredited investors (net worth of $1 million or more).

To Join — Go Here Now.