Last week, I wrote an article on Warren Buffett (Trades, Portfolio) and his advice to investors to stay away from debt at all costs.
Follow Warren Buffett's Advice: Stay Away From Debt
My fellow GuruFocus contributor John Engle took another look at Buffett's advice earlier this week in an article titled, Does Warren Buffett (Trades, Portfolio) Ignore His Own Advice?
Engle's article focused on Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial)'s use of leverage over the years to enhance investment returns -- exactly the opposite to the advice Buffett has issued to others over the years.
The article points to a previous research note written by Almington Capital, which concludes:
"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."
Following this article, I thought it was necessary to add some more color to the subject of Buffett and leverage.
Buffett and debt
As with most subjects in investing, Buffett's advice is open to interpretation. Yes, he has used leverage over the years, and in significant amounts.
The latest debt splurge was in 2016, when Berkshire asked investors for $9 billion to finance part of its $36 billion takeover of Precision Castparts. Investors were so eager to get in on the deal, orders for the $9 billion issue surpassed $34 billion.
Berkshire Hathaway's subsidiaries are also heavy debt users. However, Buffett never guarantees the debt when he takes over a company, and subsidiaries are on their own if they run into trouble by issuing too much. As Buffett declared in the 2014 Berkshire annual report:
"Berkshire does not guarantee any debt or other borrowings of BNSF, MidAmerican or their subsidiaries."
In the 2005 letter to shareholders, Buffett added more background to the debt argument, stating that Berkshire only used debt for three purchases (edited for clarity):
"We occasionally use repos as a part of certain short-term investing strategies that incorporate ownership of U.S. government (or agency) securities. Purchases of this kind are highly opportunistic and involve only the most liquid of securities."
"We borrow money against portfolios of interest-bearing receivables whose risk characteristics we understand. We did this in 2001 when we guaranteed $5.6 billion of bank debt to take over, in partnership with Leucadia, a bankrupt Finova (which held a broad range of receivables). All of that debt has been repaid."
"At MidAmerican, we have substantial debt, but it is that company’s obligation only. Though it will appear on our consolidated balance sheet, Berkshire does not guarantee it. Even so, this debt is unquestionably secure because it is serviced by MidAmerican’s diversified stream of highly-stable utility earnings."
So, it is clear that Buffett does use debt, and this is something I didn't explore in my previous article. That said, it should also be clear that you are not Warren Buffett (Trades, Portfolio).
The average investor should not be using leverage, no matter how cheap or plentiful is. Buffett has a fantastic reputation for conservative management and a love of cash; therefore, lenders are happy to lend to him with favorable terms.
There is also the insurance business to consider. Buffett's insurance float is widely cited as being akin to leverage, in effect borrowing from policy holders by taking in insurance premiums up front and playing out claims later on.
An article in The Economist in 2012 highlighted a study, which showed that Buffett has been able to leverage his capital by 60% using this approach. This might be true, but it is not a suitable conclusion for most investors. The study also pointed to the fact that, by using this source of leverage, Buffett has been able to borrow at 2.2% on average. That's not just in recent years --Ă‚ that's 2.2% on average since 1989. In comparison, the average Fed funds rate for the past four decades is 5.3%.
You are not Warren Buffett
The conclusion to this debate is simple: Buffett might be comfortable using some leverage, but investors should not follow his example. Buffett is an exceptional investor, and 99.99% of people will never come close to his success.
He is able to use moderate levels of debt because of his reputation and hard work building an international cash generative conglomerate. Buffett stands out because he has been successful. A quick search of "bankrupt billionaires" online shows just how easy it is to let leverage get the better of you.
Buffett might have broken his own rule, but that does not mean you should. To avoid any kind of temptation, it is better just to stay away.
Disclosure: The author owns shares of Berkshire Hathaway.
