"I've seen more people fail because of liquor and leverage -- leverage being borrowed money. You really don't need leverage in this world much. If you're smart, you're going to make a lot of money without borrowing." -- Warren Buffett (Trades, Portfolio)
The 2008 financial crisis was a wake-up call for the world. After decades of easy money and lax regulation for the banking sector, the financial world suddenly found itself staring over a cliff edge as liquidity and access to finance dried up.
The resulting crash has taken 10 years to recover from (and you can argue that even today the world has not fully recovered). But even after what has become known as the Great Financial Crisis, it seems the world has not learned its lesson about debt.
Earlier this year, the International Monetary Fund published a report claiming that global debt hit a record $237 trillion in the fourth quarter of 2017, more than $70 trillion higher than a decade earlier. S&P 500 margin debt also hit a record high toward the end of last year.
The world seems to be addicted to debt, and lower for longer interest rates have only worsened the situation. With interest rates beginning to rise, and the prospect of inflation rearing its ugly head around the world, it could only be a matter of time before the whole tower comes crumbling down once again. With this being the case, it has never been more critical to understand and follow Warren Buffett (Trades, Portfolio)'s rules on debt.
Stay away from debt
As one of the wealthiest men in the world with a huge cash cushion at Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) behind him, it is relatively easy for Buffett to borrow to juice returns. But he has always avoided borrowing significant amounts, even though it could have improved his returns substantially:
"Our consistently-conservative financial policies may appear to have been a mistake, but in my view were not. In retrospect, it is clear that significantly higher, though still conventional, leverage ratios at Berkshire would have produced considerably better returns on equity than the 23.8% we have actually averaged. Even in 1965, perhaps we could have judged there to be a 99% probability that higher leverage would lead to nothing but good. Correspondingly, we might have seen only a 1% chance that some shock factor, external or internal, would cause a conventional debt ratio to produce a result falling somewhere between temporary anguish and default." -- 1989 letter to investors.
As Buffett describes, Berkshire could have enhanced its returns significantly by borrowing money, with a minimal chance of loss. Even this 1% chance is too much for Buffett to risk, however, as his whole strategy rests on being greedy when others are fearful:
"We wouldn't have liked those 99:1 odds - and never will. A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns. If your actions are sensible, you are certain to get good results; in most such cases, leverage just moves things along faster. Charlie and I have never been in a big hurry: We enjoy the process far more than the proceeds - though we have learned to live with those also." -1989 letter to investors.
The desire to remain debt-free has other layers behind it as well. Buffett has a fiduciary duty to his investors (he is the largest shareholder of Berkshire Hathaway, after all) and customers of insurance subsidiaries.
If the conglomerate begins to struggle under an enormous debt load, trust between parties will quickly degrade, which could lead to a downward spiral at Berkshire.
"We are not interested in incurring any significant debt at Berkshire for acquisitions or operating purposes. Conventional business wisdom, of course, would argue that we are being too conservative and that there are added profits that could be safely earned if we injected moderate leverage into our balance sheet.
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Maybe so. But many of Berkshire’s hundreds of thousands of investors have a large portion of their net worth in our stock (among them, it should be emphasized, a large number of our board and key managers) and a disaster for the company would be a disaster for them.
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Any other approach is dangerous. Over the years, a number of very smart people have learned the hard way that a long string of impressive numbers multiplied by a single zero always equals zero. That is not an equation whose effects I would like to experience personally, and I would like even less to be responsible for imposing its penalties upon others." -Â 2005 letter to investors.
Average investors can learn a lot from this. While we may not be running a multinational insurance group or managing money on behalf of others, we still have most of our wealth invested, and we could eliminate years of hard work by taking on too much debt.
Even though the prospective greater returns from leverage might be attractive, the risks of excessive borrowing far outweigh the potential rewards. It is best just to stay away.
Disclosure: The author owns shares of Berkshire Hathaway.
