Warren Buffett (Trades, Portfolio)'s 2018 letter to shareholders of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) contained plenty of information and insight, covering everything from buybacks to look-through earnings and "The American Tailwind."
In the letter, Buffett also wrote about debt (as he has done many times in the past) and why Berkshire has always tended to stay away from taking on too much leverage.
Specifically, the Oracle of Omaha opened his section on debt with the following:
"We use debt sparingly. Many managers, it should be noted, will disagree with this policy, arguing that significant debt juices the returns for equity owners. And these more venturesome CEOs will be right most of the time."
He went on to say:
"At rare and unpredictable intervals, however, credit vanishes and debt becomes financially fatal. A Russian roulette equation -- usually win, occasionally die -- may make financial sense for someone who gets a piece of a company’s upside but does not share in its downside."
Buffett goes on to remark in his letter that this "strategy would be madness for Berkshire" because "rational people don't risk what they have and need for what they don’t have and don’t need." I think this is a fantastic piece of advice, both from an investment perspective and a personal finance perspective.
Leverage and Russian roulette
Many companies have successfully used leverage to boost returns. There have also been many companies that have failed by taking on too much leverage. In most cases, owner-operated companies (a tiny sliver of the S&P 500) do not borrow significant amounts of money because the owner has just as much or probably more to lose than investors (apart from John Malone, who is in a class of his own).
When the owner is not invested, however, they have almost nothing to lose and everything to gain, particularly if compensation arrangements are tied to stock price performance. If you get a bonus every year, why does it matter if the company employed two years after you've left?
The rest of the quote is food for thought for investors and savers who are happily borrowing away on their credit cards: "Rational people don't risk what they have and need for what they don’t have and don’t need."Â
Borrowing for the long term
In his letter, Buffett went on to say the only debt Berkshire really has is at its railroad and energy subsidiaries, which are both "asset-heavy companies." He continued, saying, "During recessions, the cash generation of these businesses remains bountiful," therefore justifying the level of borrowing. This, I think, is another fascinating insight into Buffett's way of thinking. He is happy to take on debt as long as the businesses are not cyclical and can sustain borrowing throughout the cycle without having to worry about getting into financial difficulty.
Buffett has been able to build the business empire he presides over today through careful financial management and a long-term focus. His refusal to borrow significant amounts of money is just part of the equation. Using debt to buy what you can't afford, or to expand the business faster, might seem like an attractive prospect at first, but high levels of borrowing tie your hands — debt limits flexibility, particularly when you need it most: in economic downturns or down cycles.
Over his nearly seven decades of investing, Buffett has observed the best way to get rich is to be flexible, and greedy when others are fearful. You cannot do this if you have borrowed too much money and are reliant on the goodwill of others. The biggest financial collapses of all time have been a result of high levels of leverage -- that's a lesson in fiscal prudence investors of all experiences can understand.
Disclosure: The author owns shares of Berkshire Hathaway.
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