One of the most common talking points among financial professionals concerns the use of leverage, either by businesses or by investors.
It’s pretty popular to say that the prudent investor should never use borrowed money, but this blanket statement certainly isn't repeated by everyone. Berkshire Hathaway’s (BRK.A, Financial) (BRK.B, Financial) Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) have in the past used leverage to increase their returns.
In a set of remarks delivered at the Massachusetts Institute of Technology Sloan School of Management, value investor Seth Klarman (Trades, Portfolio) explained the situations when leverage can be useful, as well as when it can be hazardous.
Recourse versus nonrecourse debt
Klarman is a famously conservative investor, adhering rigorously to Buffett’s number one rule of investing: “never lose money.” So with that in mind it is perhaps interesting to note that he doesn’t believe that leverage can never be used judiciously.
The main distinction for Klarman is between recourse debt and nonrecourse debt. In the former case, the borrower is personally liable for any losses incurred, whereas in the latter case only the collateral put up for the loan is at risk.
In fact, a nonrecourse loan taken out against an asset that you already own can actually reduce the risk of an investment, because you are then able to use the borrowed capital to buy other assets without having to worry about them declining in value. By contrast, a recourse debt exposes you to far more risk:
“If you purchase some investments, and then borrow with recourse debt to buy more, you are now vulnerable to mark to market losses in what you own. Depending on the precise terms of the debt, a decline in the value of your holdings could force you either to put up more collateral - which you may not have - or to sell off some of the investments you purportedly like to meet margin calls. By borrowing, you have ceased to be the master of your own fate and allowed the lender - or actually the market - to be. How ironic to allow the market, which has dished up your current portfolio of opportunity, to dictate to you the need to sell your attractive holdings in order to survive.”
The problem with investing with money borrowed via a recourse loan is that you don’t have the luxury of waiting out periods when the price of your investment drops. For a value investor who is secure in their analysis of a business, a price drop is just an opportunity to buy at even more attractive levels. But with borrowed money, it is inverted - the leveraged investor lives in fear of receiving a margin call from his brokerage, and so can only hope that prices go up instead of down, which is not a position that anyone wants to find themselves in.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Howard Marks: How to Define Your Risk
- Bill Ackman Is Positive on Real Estate
- Forensic Accountant Harry Markopolos Talks Fraud
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