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John Engle
John Engle
Articles (176) 

Buffett on Leverage: Do as I Say, Not as I Do?

The Oracle of Omaha seems to act against his own advice – and win

April 20, 2018 | About:

Warren Buffett (Trades, Portfolio) is unquestionably the greatest living value investor, so whenever he gives advice it is a good idea to listen closely. In late February, during an interview with CNBC, Buffett dished on a range of investment-related topics, but his chief concern of the day was leverage. Specifically, he outlined his disdain for financial leverage, calling it “crazy.” He also invoked the words of his long-time associate, Charlie Munger (Trades, Portfolio):

"My partner Charlie says there is only three ways a smart person can go broke: liquor, ladies and leverage," he said. "Now the truth is — the first two he just added because they started with L — it's leverage."

Leverage can be a powerful tool, but it is definitely a Sword of Damocles: While it can juice up returns, it also magnifies losses. A bad turn can annihilate a portfolio. For investors hunting for deep value or market irrationalities to exploit, a heavily leveraged strategy can blow up in their faces, even if they are right over the long run. Even Buffett’s own Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) has experienced major drops at various points in its long history – drops that would have blown up a portfolio with any significant leverage.

Yet, for all his apparent disdain for the use of leverage in stock purchases, one could claim that Buffett uses it quite liberally at Berkshire.

Today, we take a look at Buffett’s stance on leverage, how he uses it, and what it can mean for investors building their investment strategies.

Buffett’s negative take

Buffett’s case against leverage is quite straightforward, and he has been making it for quite a while. He mused on the subject in his latest letter to Berkshire shareholders:

“There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren't immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions."

Leverage is dangerous, sure. But does that mean it has no utility?

Buffett’s uses for leverage

In truth, Buffett is not quite so anti-leverage as he sometimes makes out. Indeed, a 2014 academic study found that Berkshire Hathaway had been leveraging its capital by as much as 60% and that that level of leverage was a major factor in Berkshire’s outsized returns.

So how do we reconcile Buffett’s words and his actions? Well, we can look first to where his leverage comes from.

Buffett uses its float, the free cash from its sprawling insurance businesses, to act as a source of cheap financing for acquisitions and investments. In essence, this is a sort of internal operational leverage, as opposed to an external financial leverage (such as buying stocks on margin). Unquestionably, this is a much safer and cheaper way of accessing leveraged returns. And while it is definitely not available to most of us mortals, it is still definitely a kind of leverage.

So what about financial leverage?

We might be accused of comparing apples and oranges by holding Berkshire’s leverage methods next to ordinary margin investing. But the principles have much in common and require similar outlook. The margin investor must certainly also be very aware of the risks involved and manage exposure very carefully.

Margin is a dangerous tool, but, if used wisely and judiciously, can be wonderfully useful. We have made use of it in our own formal trading strategies in recent years, but have always focused on maintaining sufficient cushion to not get the dreaded margin call.

While we would generally recommend doing as Buffett says, it might be better to do as he does – or near enough as investors and investment businesses can without access to a vast float.

But always be careful. Buffett is right that an unwary investor can lose his shirt, and fast, when using leverage injudiciously.

Disclosure: I/We own none of the stocks discussed in this article.

About the author:

John Engle
John Engle is President of Almington Capital - Merchant Bankers. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin and an MBA from the University of Oxford.

Rating: 5.0/5 (1 vote)

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Comments

investrule1
Investrule1 premium member - 3 months ago

No facts, no research, only trivial opinion.

batbeer2
Batbeer2 premium member - 3 months ago

Hi John, thanks for sharing your thoughts. Of course, any criticism of Buffett on this forum will be frowned upon :-).

Here's my thoughts:

1) You say: Margin is a dangerous tool, but, if used wisely and judiciously, can be wonderfully useful.

I'd argue that anyone not smart enough to generate satisfactory returns without leverage is too dumb to use leverage judiciously. You might disagree with that but then I'd ask you where you draw the line.

BTW, anyone having trouble understanding exactly what satisfactory returns are, is very likely driven by envy. Envy truly is the worst of demons.

2) You say you use margin for leverage. Have you considered any other forms of leverage? Why is margin the best form in this case?

3) Since you seem to be managing other peoples money, how do you adjust your compensation to strike the correct balance between your ability to correctly identify superior stocks and the amount of leverage you add to the mix. You see, if you give me a fund to manage and I buy a cheap index fund and add 20% leverage then I'm certain to beat the index in most years and also over time. I could just go fishing. I get paid good money most years. In your line of work, how do you adjust for that?

4) Finally, do you have any thoughtrs about layering leverage? Let's say you are running a fund with 10% leverage but your clients borrow 10% to invest in your fund. Meanwhile the company you've invested in also has some debt. Let's say 10% of assets. All three could argue that thety are acting well within acceptable limits but where does the cummulative risk (if any) lie?

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