Debt is one of the most important topics in personal finance and investing.
From a personal finance perspective, avoiding getting into debt and paying down expensive debt is one of the simplest things anyone can do to improve their financial situation.
From the perspective of an investor, highly leveraged companies can be terrible investments.
When a company has a lot of borrowing, it gives up a certain amount of control over its future.
The same is true when it comes to margin investing. Investors borrowing money to invest give up complete control over their investments. They become tied to creditors' restrictions and demands.
Having said all of the above, it is important to note the role debt and leverage has played in helping some of the world's most successful investors and business people build their fortunes.
The role of debt
There are many examples of this. For instance, before he became an investor in the early part of his career and was developing real estate projects, Charlie Munger (Trades, Portfolio) used debt to help finance these projects. Then, when he started investing, he wasn't afraid to borrow large amounts of money to invest in securities where he believed there was a high chance of a significant payoff.
Alice Schroeder's book, "The Snowball: Warren Buffett and the Business of Life," cited the following example:
"Munger did enormous trades [with borrowed money] like British Columbia Power, which was selling at around $19 and being taken over by the Canadian government at a little more than $22.
Munger put not just his whole partnership, but all the money he had, and all that he could borrow into an arbitrage on this single stock--but only because there was almost no chance that this deal would fall apart."
Warren Buffett (Trades, Portfolio) has also used leverage to help him throughout his career. This is not debt in the traditional form, but it is instead Berkshire Hathaway's (BRK.A, Financial) (BRK.B, Financial) investment "float." This is the money paid in insurance premiums by customers of the insurance business but not yet paid out in claims. If the insurance business remains profitable, this is essentially interest-free cash.
Buffett and Munger are just two examples. Carl Icahn (Trades, Portfolio) leaned heavily on debt in the first half of his career. He was one of the buyout giants, which were funded with junk bonds. The junk bond boom of the 1970s and '80s created a whole class of Wall Street buyout kings sponsored with easy credit.
Ray Dalio (Trades, Portfolio)'s fund, Bridgewater, has always leaned heavily on debt to improve returns. The main principle behind the firm's leading funds is that by leveraging up safe assets, investors can improve returns without taking on more risk. The strategy has worked over the past few decades.
Many other investors have used debt quite successfully over the years to grow and improve returns. One of the greatest businessmen of all time, John D. Rockefeller, reportedly used to ride to every bank he knew to borrow as much money as possible when acquiring new refineries or buying Standard Oil shares for his own account.
Other people's money
The point is not to prove that debt is good. That is not correct. These are just the examples that worked out. There's only ever been one Rockefeller, and there are nearly 8 billion people in the world today. Those are long odds.
However, debt and leverage can be used successfully when used intelligently. After all, one of the easiest ways to accrue money is to borrow it from lenders or to use other people's money. That's something all of the investors outlined above worked out early on and made the most of throughout their careers. Unfortunately, there's no set formula to say how much debt is enough or if a strategy involving debt will work out. That's what makes it so risky.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Warren Buffett and the 'Degree of Difficultly' in Investing
- Finding an Investment Strategy That Works for You
- Trying to Place a Value on Berkshire Hathaway
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