Warren Buffett writes an annual letter to Berkshire Hathaway shareholders, which generally has a useful investing lesson or two from the Oracle of Omaha himself.
In the latest instalment, Buffett attempted to highlight the dangers of using leverage to invest, as well as the benefits of avoiding it. In short, debt can be an investor’s worst enemy, but avoidance of debt can become their best friend.
Warren Buffett hates debt
Warren Buffett is a big fan of avoiding debt. This is true in Berkshire Hathaway’s operations, as well as with the stocks he buys for the company’s portfolio. A large amount of debt is a big red flag for Buffett as an investor.
Not only does Buffett not like to carry any net debt on Berkshire Hathaway’s books, but he also insists on keeping substantial sums of cash in reserve. While the current $116 billion cash hoard is extremely high, even for Berkshire, Buffett has said that he likes to keep at least $20 billion on hand to maintain a level of financial flexibility that most other companies simply can’t match.
So, it shouldn’t be a big surprise that Buffett’s lesson for his shareholders this year is that they should never buy stocks (even Berkshire) using borrowed money.
Berkshire Hathaway is widely considered to be a relatively safe and low-volatility stock, which has performed extraordinarily well over time.
However, Buffett is the first to point out that the company’s path hasn’t been straight up. In fact, there have been four large drops along the way.
Buffett also points out that dips like these are highly unpredictable, and that similar drops will happen again in the future. “The light can at any time go from green to red without pausing at yellow,” Buffett wrote.
Why investing with borrowed money can be so dangerous
To be sure, investing with borrowed money can look like a genius move when stock prices keep going up. And anybody who bought blue chip stocks on margin over the past couple years is probably doing just fine.
The problem is that, as you can see in the chart above, stocks don’t go up in a straight line forever. At some point they’ll fall, and people who are overleveraged will get crushed.
Here’s a hypothetical example. Let’s say that while Berkshire was trading at $147,000 in 2008, you wanted to buy some shares. You bought one share with your own money and then borrowed another $147,000 to buy a second class A share. Although your investment only had a net value of $147,000, you owned the upside (or downside) on $294,000 worth of stock.
About six months later, when the stock bottomed at $72,400, you’d have $149,200 worth of losses or more than you had. You’d not only have lost everything, but you would owe your broker $2,200 plus the margin interest on the borrowed money. In reality, your broker would have forced the sale — known as a margin call — sometime before it got this bad. So not only would you be left with very little money, but you would have been forced to sell at the bottom.
On the other hand, debt-free investors were undoubtedly concerned by the price drop, but weren’t put in a position where they had to sell; they were able to hang on through the tough times. Since then, Berkshire’s class A share price has risen to more than $300,000.
Market crashes: Your best friend or your worst enemy
The point is that when you invest with debt, stock market crashes can be your worst enemy. Conversely, if you’re a long-term investor with financial flexibility and no debt, they can be a reason to smile.
I mentioned earlier that Buffett likes to keep at least $20 billion of cash on hand; this is just as valuable a lesson as avoiding debt. As Buffett said in his letter, “When major declines occur … they offer extraordinary opportunities to those who are not handicapped by debt.”
You and I are unlikely to have billions of dollars on hand. But if your portfolio is debt-free and has a substantial amount of cash, you’ll be able not only to survive tough times, but to take advantage of them. It’s worth noting that Berkshire’s $20 billion figure is roughly 5% of the company’s market cap, and keeping a similar percentage of your portfolio in cash is a smart idea.
After all, it’s this level of financial flexibility that allowed Berkshire to take advantage of the bargains offered by the financial crisis, such as acquiring its massive Bank of America investment, now worth more than $20 billion, for less than one-fourth of its current value.
To sum up: I know tons of people (myself included) who wish they’d had more cash available to invest when the financial crisis hit. But I don’t know a single person who has said to me: “I’m sure glad I borrowed money to buy stocks in 2007.”