Make a Fortune the Warren Buffett Way: Using Other People's Money

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My dad worked all the time when I was a kid. But early on Saturday mornings, he'd wake me while it was still dark and take me to the office with him.

And about once a month, we'd slip away to the farm where he grew up and there he worked just as hard, doing farm chores in blue jeans instead of business deals in a suit and tie. Other times we'd visit oil wells, look at farm properties or cattle. He liked to drive and talk, and sort things out.

Listening to my old man unwind was a phenomenal business education.

On one of these trips, Dad was talking about some rental property he and a partner were going to buy together. He explained the nuances of deal's financing and then he looked up at me.

"You know the best way to build equity, don't you, son?"

Bear in mind that I was maybe 7 years old, but I knew the difference between debt and equity. But as I pondered Dad's question, I came up short.

I shook my head. "I don't know, Dad," I said.

He smiled my favorite smile, a sort of sideways, in-the-know, "gotcha" diabolical smile. "The best way to build equity, my boy," Dad held forth, "is with someone else's money."

His point was that, over time, the tenants would do the heavy lifting -- paying themortgage and expenses while he and his partner got some income, increased their equity and, potentially, also saw the value of their property rise.

A couple of years later, Dad took me on a trip to Nebraska. We went to a big conference hall where two old men sat at a table. They looked like every small-town banker I had ever met and, once they started, they talked non-stop for almost the whole day. Dad sat there and took notes. I was bored.

Finally, I heard the man talk about the investment portfolio. He kept using a word that would haunt me for days. Then I made my discovery.

"You know what he's doing, don't you?" I asked, waving a copy of theannual report .

"What who's doing," my mother asked.

"That guy in Omaha. That Mr. Buffett!" I said. "He's building equity with other people's money!"

My old man smiled and nodded. He looked like he was about to burst with pride.

Other people's money
The word that haunted me was " float ." But it didn't describe the verb I found listed in the dictionary on my bookshelf. This float was a noun, a type of money. In an insurance context, "float" refers to money held for policyholders to cover their claims.

The purpose of an insurance company, from a customer's perspective, is to offer protection from financial loss. For this coverage, drivers pay premiums. But if it ended there, most insurance companies wouldn't make aprofit -- policyholder claims generally exceed premiums paid.

So to really understand insurance companies, you have to look at them from the board of directors' perspective. It's then that you see the purpose of an insurance company isn't to provide coverage, it's to borrow money and invest it -- a lot of money.

After all, if you have 10 million policy holders paying $100 a month for car insurance, then that's $1 billion piling up every 30 days. That money is the "float." Most, if not all, will eventually be paid out. The key word there is "eventually." In the meantime, the insurance company is free to continue to collect premiums and invest the float for its own benefit.

The question, of course, is precisely where is all that money invested? When investing such a large sum, professionals spread it around and seek to profit from all sorts of investments.

As many of you know, I'm the editor of Fast-Track Millionaire . I'm always looking for those securities on the "fast-track" to triple, or quadruple-digit gains.

So knowing what stocks the big insurance houses are buying doesn't go far enough for me. A lot of what insurance companies are buying are large, stable companies that provide a relatively predictable rate of return.

What I'm looking for is the portion of each stock portfolio allocated to smaller companies with greater potential for exceptional returns. These picks have been vetted by some of the sharpest minds in finance -- insurance companies hire top managers to tend to their trillions.

Action to Take --> Here's a small sample of what I found:

State Farm
State Farm has a roughly $40 billion stock portfolio that covers only 95 securities. This is a relatively narrow universe of picks for such a sum, so I'd say State Farm is willing to make some pretty bold picks. While its largest holdings are no surprise -- Johnson & Johnson, ExxonMobil, IBM, Hewlett-Packard, Archer Daniels Midland -- there was one company that looked promising: Medidata Systems (Nasdaq: MDSO) .

Factory Mutual Insurance Co.
Factory Mutual is more commonly known as FM Global, and it's a go-to insurance provider for companies that need to cover major pieces of property. Its stock portfolio is worth $4 billion and covers about 160 securities. While nearly every one of these stocks is a mega-cap company, one small company has made the cut, Cadence Design Systems (Nasdaq: CDNS) .

Allstate
Allstate's $1.6 billion portfolio is spread across more than 1,000 stocks. One gem that stuck out in this sea of small positions was Spansion ( CODE ) . [ Note: Remember that no matter the broader market, there are always winning stocks to own. Click here to read the details of some of the biggest winners over the past decade... and a few opportunities I'm seeing now.]  


--Andy Obermueller

P.S. -- I added Medidata Systems to my Fast-Track Millionaire model portfolio back in November. It now trades at $26, so we're up 34.8%. My target is $50 a share.

Disclosure: Neither Andy Obermueller nor StreetAuthority, LLC hold positions in any securities mentioned in this article.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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This article appears in: Investing , Basics , Investing Ideas

Referenced Stocks: CDNS , CODE , MDSO

Andy Obermueller

Andy Obermueller

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