About 12 years back, I first came to Bangalore to join my first job in IT industry. Known as city of lakes and the silicon valley of India, Bangalore was the place to be in.
However, the initial euphoria soon evaporated when I was told by the real estate agent that renting a house required me to deposit an advance. What added insult to the injury was the size of security deposit amount. It was supposed to be 10 months of rent.
Holy cow! That was several times more than my monthly salary at that time.
But it turned out that the practice was pretty common in Bangalore, and still is, which I suppose is not the case in other metros.
It infuriated me that the house owner would conveniently put that advance money in his bank and pocket the interest income too. So in effect he wasn’t just making money from rent, but from free deposit also.
Now here is an interesting question to puzzle over. The security deposit which in effect was a borrowing for the house owner – can we call that money as debt for him?
Yes and No. ‘Yes’ because it’s not his money and he would have to return that money sometime in future and ‘No’ because he doesn’t have to pay any interest on this borrowing.
So it’s a debt but quite different from a traditional debt. Let’s see how.
When I moved out from his house, the money which he returned to me was replenished by the new tenant. So it was a revolving fund. Effectively he would never have to return that money to his tenant, provided he doesn’t run out of tenants, which is unlikely because his house was in busy locality in Bangalore.
The deposit was an income generating asset which costed the landlord nothing. He could very well be using that money for making other investments too, like buying stocks or making down payment for another house.
So this is a very interesting type of debt. It’s called Float.
Here are the three characteristics of Float which separates it from the plain vanilla debt.
- There is no collateral in float. If the house owner refuses to return my security deposit, there is no easy way for me to recover my money.
- There is no, as we saw, interest either. The house owner doesn’t pay any interest on the money that he borrowed from me.
- It’s long enduring i.e. you don’t have to return the money. The security deposit was a revolving fund and hence always available.
So we see that conventional debt is onerous. But this float thing sounds like a ponzi scheme, doesn’t it?
Well, it’s not just the case of security deposits, there are numerous other businesses which use this idea of float to generate better returns on their capital.
In fact, there is a whole industry which is founded on the idea of float. Can you guess? The insurance business.
Those who are familiar with Warren Buffett and his company Berkshire Hathaway, know that Buffett built his business empire by using the float from his insurance subsidiaries.
According to him, ￼Float, is in effect, the money that we are holding that eventually will go to other people, but of which we have temporary possession.
So how does float work in insurance business? Let’s hear straight from the horse’s mouth. Buffett’s wrote in his 2002 letter to investors-
…float is money we hold but don’t own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money. This pleasant activity typically carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an “underwriting loss,” which is the cost of float. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money. Moreover, the downward trend of interest rates in recent years has transformed underwriting losses that formerly were tolerable into burdens that move insurance businesses deeply into the lemon category.
For a typical insurer, the premiums it takes in do not cover the losses and expenses it must pay. That leaves it running an “underwriting loss” – the cost of float – which is the functional equivalent of interest on conventional debt.
So the float is useful in insurance only if the cost of float is less than the prevailing interest rates. A low cost float is great but what’s even better is a free float i.e. one where the cost of float is zero. Now, this calls for an insurance business to run its operations efficiently and ensure that the insurance premiums are commensurate with the risks.
That’s precisely what my landlord was enjoying. A free float. And with increase in rent every year, which resulted in bigger security deposits, his float was increasing too.
There is no dearth of businesses which generate float. Even a loss making insurance business generates float but what makes float attractive is its low cost. There is no other form of financing better than free float. Or is there one?
Wait! There is one, at least for Warren Buffett because he’s always one step ahead. Most of Buffett’s insurance business have a negative cost of float (better than free) which means his businesses are run super efficiently. Buffett writes –
If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it. That’s like your taking out a loan and having the bank pay you interest.
To see how important the idea of float is for a business, let’s invert the problem. Assume that a business can’t generate float. What are the other source of funds to replace the float?
Debt? But conventional debt isn’t free, rather it’s quite expensive. The interest on debt will reduce the earnings. What about equity? Well, raising money through equity will lead to dilution. Not a desirable option for existing shareholders.
The more of an asset that you can fund with a free float, the less the need to fund it with expensive debt or equity becomes.
Buffett’s tryst with float started in 1960s when the salad oil scandal attracted his attention to American Express. The scandal created a one time liability of $150 million for Amex which tanked the stock price. However, Buffett discovered something interesting in Amex’s balance sheet.
Amex was carrying a liability of half a billion dollars which was money paid to Amex by its customers in lieu of a piece of paper, i.e. Traveller’s Cheque. There was neither any collateral nor any interest associated with liability. The paper was redeemable at demand, but there was always a lag between issue and encashment and sometimes people even forgot to encash them. More importantly, when people encashed them, there were others who bought new TCs, so the balance in the liability account had become a “revolving fund.”
It was a no-brainer for Buffett to pull the trigger on a heavily loaded gun. He accumulated 5% of Amex, amounting to a total of 40% of Buffett’s total portfolio at that time. Within two years that investment multiplied by more than 2.5 times. Float baby float!
Today, Berkshire’s insurance operations generate a float of $88 billion with an underwriting profit of $1.8 billion. Isn’t it incredible that Buffett is getting paid in billions for holding on to other people’s money?
That’s the magic of float.
Few More Floats
The simplest example of a float is the gift card issued by retailers. Yes, that Amazon gift card! The issuer gets paid for it upfront, and there is quite a bit of lag until the giftee uses it. And there are people who only make a partial use of the gift card leaving free money on the table for the issuer. Some even forget to encash the gift card and some gift cards expire before they can be used. More free money!
No wonder many consider gift card industry the biggest billion dollar scam.
Can you think of some more examples of float around you? Here are few that comes to my mind –
- The tickets that you book (airlines and train) in advance. When a waitlist train ticket is booked 2 months in advance only to be cancelled (most of them) at the last moment, the money keeps lying with railways for 2 months. Isn’t that a free float? How profitably this float is used/misused is another question altogether.
- When you get a refund from an online-store, they usually credit your virtual wallet. That money is an interest free loan for them. However, the current regulation in India doesn’t allow these online stores to use that money for other purpose, so not exactly a real float here.
- If you use your credit card you get a free credit for a month from the credit card company. By the time you settle your last month’s credit card bill, you would have accumulated another month’s expenses on credit card. Effectively you’re revolving funds (equal to your monthly expenses) on your credit card. It’s a free float for you. Of course, just like underwriting discipline is required for profitable insurance operations, credit card float is useful only if you’re using it prudently and not incurring a high cost of float (late fee and astronomical credit card interests).
Source of Float
We have seen how insurance business generates float. Now if you own a non-insurance business and intend to generate float, what are your options?
Here’s what Prof. Bakshi has to say –
Businesses employ assets. These assets can be financed by (1) Equity; (2) Debt; and (3) Float. Float is preferable if it’s free or cheap and if it’s long-enduring. Recall float is Other People’s Money. Who are the other people? They aren’t equity, and they aren’t debt. So who can they be? Well there are only four main categories: suppliers (trade credit, deposits from distributors), customers (advance from customers), employees and government (deferred taxes). Let’s focus on suppliers and customers.
What kinds of businesses are those where suppliers and/or customers provide float? Those with moats. [These are the] businesses which dominate their markets [and] can dictate their terms.
Suppliers will provide lenient credit and not charge higher prices (no implicit interest). Customers will pay in advance and not ask for cash discount (no implicit interest). Distributors will give interest free deposits.
Negative working capital without implicit interest.
￼Amazon is one such businesses which funds all its assets (including fixed assets, receivables and inventories) by other people’s money (account payables and accrued interests). As per 2015 annual report, their negative working capital is more than $13 billion. And it’s growing every year.
When you buy something from Amazon, they get the money almost immediately but most of the distributors/publishers don’t get their payment until 90 days. The bigger Amazon grows, the more cash it gets to hold. The faster it turns the inventory, the bigger its cash grows.
Most people just look at a company’s margins and judge the quality of the business model based on that, but the cash flow characteristics of the business can make one company a far more valuable company than another with the exact same operating margin. Amazon could have had a margin of zero and still made money. (source: http://www.eugenewei.com/blog/2012/11/28/amazon-and-margins)
And Amazon is not unique when it comes to creating floats using negative working capital. Lot of FMCG companies, like HUL, have strong moats because of this kind of float in their balance sheets.
Mahindra holiday’s (MHRIL) is another business with an interesting business model which generates large amount of float. As of 2015, the company had advances from customers totalling to Rs. 1500cr, which is more than 50% of the balance sheet.
However, the receivables are also pretty high (Rs. 870 cr) which offsets the float quite a bit but you need to dig further and find out what’s going on here.
Consider it as your homework for today 🙂
Nesco, the company behind Bombay Exhibition Center, also carries float on its balance sheet. It gets the exhibition fee in advance. Not just that, the commercial space that Nesco has leased out generates float in form of advance security deposits.
The standard accounting calculations consider the float as normal liability, like conventional debt, which introduces inaccuracy in evaluating a business’s true value. Presence of large float in a balance sheet can skew the real picture.
Buffett, in his latest (2015) letter to shareholders, writes –
So how does our float affect intrinsic value? When Berkshire’s book value is calculated, the full amount of our float is deducted as a liability, just as if we had to pay it out tomorrow and could not replenish it. But to think of float as strictly a liability is incorrect. It should instead be viewed as a revolving fund. Daily, we pay old claims and related expenses – a huge $24.5 billion to more than six million claimants in 2015 – and that reduces float. Just as surely, we each day write new business that will soon generate its own claims, adding to float.
If our revolving float is both costless and long-enduring, which I believe it will be, the true value of this liability is dramatically less than the accounting liability. Owing $1 that in effect will never leave the premises – because new business is almost certain to deliver a substitute – is worlds different from owing $1 that will go out the door tomorrow and not be replaced. The two types of liabilities, however, are treated as equals under GAAP.
So we learnt that float is an important mental model to think about businesses especially if you’re looking for hidden moats.
Now before I wrap up here, let me take the risk of sounding like a broken tape. Because we can never over-emphasize the importance of building these mental models.
If you’re into the business of long term investing, these mental models are the tools that help you navigate smartly. These big ideas from multiple disciplines, give you a tremendous edge as an investor and as a thinker. There, I said it again – like a broken tape.
Take care and keep learning.
Notes: Many examples that I have quoted in this post come directly from Prof. Bakshi’s MDI lecture – Floats and Moats. It’s a must read.