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Why Buffett Likes Loans and Preferred Stock

Buffett can earn a high return with limited risk using large loans

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Oct 21, 2021
Summary
  • Buffett has been using large loans to deploy capital
  • These structures provide a low-risk way to earn returns
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Loaning money to businesses

An investment structure that

Warren Buffett (Trades, Portfolio) has been making more and more use of in recent decades is a loan structure.

Buffett, and by association, Berkshire Hathaway (

BRK.A, Financial) (BRK.B, Financial), have been loaning money out to other companies for decades. While the Oracle of Omaha's favorite route for investing has remained equity investing, when an opportunity has presented itself, Buffett has been quick to put together a package of debt, either with preferred equity or loans, to help finance an institution.

Berkshire started putting together these large deals towards the end of the 1980s. This is when the conglomerate began to become a force to be reckoned with in the financial markets.

The size of the business meant that it had become increasingly difficult for Buffett to deploy large amounts of cash that would move the needle in the equity markets. At this point, his reputation had also grown significantly, which would have made it difficult for him to buy a sizeable position without the stock reacting.

One of the first deals that really hit the headlines was Berkshire's $700 million investment in Solomon Brothers' preferred stock in 1987. In this case, the security was to pay 9% and be convertible after three years into Salomon common stock at $38 a share.

Two years later, in 1989, Buffett invested $600 million of Berkshire's cash in Gillette's preferred stock with an 8.75% yield.

These are not the only deals Berkshire completed using a similar structure around this time. As time has moved on, Buffett has repeated the playbook. He was particularly active during the financial crisis, when he used $5 billion to buy preferred stock in Goldman Sachs (

GS, Financial) and invested $300 million in motorcycle-maker Harley-Davidson (HOG, Financial) with a 15% interest rate.

I have already noted that these deals allowed Buffett to deploy large amounts of capital at high rates of return relatively quickly. Still, there was another reason why the Oracle decided to take this route rather than buy the equity of these companies. He explained why at the 2010 annual meeting of Berkshire investors when discussing the Harley-Davidson position:

"Now, there were different risk profiles, obviously, in investing. And the truth is, I don't know whether Harley-Davidson equity is worth $33 or $20 or $45. I just have no view on that...But I do know, or I thought I knew, and I think I was right, that, A) Harley-Davidson was not going out of business. And that, B) 15 percent was going to look pretty damned attractive...I knew enough to lend them money; I didn't know enough to buy the equity. And that's frequently the case...I think I can make very good money, as we did on Harley-Davidson, with a very simple decision, just a question of, "Are they going to go broke or not?" as opposed to a tougher decision, "Is the motorcycle market going to get diminished significantly? And, you know, are the margins going to get squeezed somewhat?" And all of that. I'll go with a simple decision."

Put simply, Buffett admitted that he didn't know a lot about the company and its market, but he did know it wasn't going to go bankrupt and he could earn a high return.

The odds of success

The odds of success were pretty high on these kinds of investments. It's a simplistic way of looking at investing, but it is one that works. Regardless of how successfull the business turned out to be, as long as they could repay their debts, Berkshire would make an easy profit.

Unfortunately, these kinds of opportunities do not come around very often, especially for individual investors. Buffett can help bail out large corporations and dictate the terms of his deals. Individual investors cannot.

Still, there were two things we can take away from this. First of all, not all of Buffett's deals are as simple as they appear. He often achieves more advantageous terms which should make investors think twice about copying his trades (an easier way to copy Berkshire's trades is to just buy Berkshire).

Secondly, good investors are flexible and focus on the probability of success as well as financial return. If the odds are attractive, one may be able to invest with limited information.

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Disclosures

I am/we are Long BRK.B
The views of this author are solely their own opinion and are not endorsed or guaranteed by GuruFocus.com
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