The writings of super-investor Warren Buffett are widely devoured by thousands of disciples eager for clues as to how to beat the market.
Not to be rude, but I can’t help thinking this is like me asking Usain Bolt for tips on how to bring my 5km time down to something a bit more respectable.
Buffett is in a class of his own – an obsessive genius with a brain that probably thinks about compound interest every six seconds.
And he’s been that way since he was a toddler.
Indeed I suspect one reason most of his investing advice sounds so folksy is that his decision-making occurs mostly below the level of consciousness.
In any event, beyond his homespun platitudes about price, value, and quality, Buffett rarely gives actionable advice about stock picking.
Yet like every other investing-obsessive, I still look forward to his annual letter to shareholders, which is published this time every year.
I don’t expect too many insights into finding market-beating investments.
But I do believe Buffett is a peerless explainer of bigger concepts, such as how businesses and the economy work, or the incentives that drive human decision-making.
And surprisingly – given he’s a multi-billionaire whose problems come with many more zeros attached to them than mine – I also find him something of a personal finance guru.
Over the years I’ve tucked away tidbits from Buffett on everything from frugality to the importance of having an emergency fund to the benefits of owning your home.
Meanwhile in this year’s just-released letter, Buffett makes a good point about debt.
Debt: The great derailer
Buffett writes that at Berkshire Hathaway, his company:
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.
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. But that strategy would be madness for Berkshire.
Rational people don’t risk what they have and need for what they don’t have and don’t need.
Buffett is talking about corporate debt juggling, but his point is equally relevant for our personal financial lives.
After all, a company can go bankrupt but the shareholders and executives can move on to new ones. But we only get one shot at living our lives!
You see, people overstretch themselves with debt in so many ways:
- The person who remortgages the family home to invest in poorly-bought rental properties that barely generate a positive cash flow and are the first to fall into negative equity in a crash.
- Another who puts off investing until they’ve cleared their credit cards – sensible enough – but who then loads more shopping onto store cards, leaving compound interest working against them instead of growing their wealth for years to come.
- The new investor who sees shares go up in a rising market, thinks “this is easy”, opens a spread-betting account without understanding that they’re borrowing to invest – and sees their portfolio wiped out by a sudden market correction.
- Another investor who knows better than to use debt, but who has a blind spot in their stock picking, which leaves them buying ‘value shares’ that trade at low multiples of earnings, without appreciating all the debt their firms are carrying to generate mediocre returns and how vulnerable they are to the next recession.
- Pretty much anyone who borrows to invest, whether through trading on margin at their broker or – yes, I’ve seen this in very frothy markets – who takes out a personal loan because “shares should do 10% a year, which is more than the interest I’ll be paying”.
Remember, the average return of shares over the long-term tells us nothing about what you’ll get in the short-term. A debt is a debt, with a fixed cost and a set day of reckoning!
It’s madness to try to make a few percent a year while leaving yourself vulnerable to a financial catastrophe.
As Buffett says, that’s Russian-roulette logic.
It’s worth stating that while Warren Buffett says Berkshire doesn’t lean heavily on debt, some of the operating companies it owns do borrow heavily. Enhancing returns with debt is standard practice in capital-intensive industries such as railroads, where there are a lot of fixed assets and steady cashflows to secure the debt against.
More to the point, Buffett also makes substantial use of Other People’s Money with the ‘float’ provided by Berkshire’s insurance companies.
Float represents premiums paid upfront by Berkshire’s insurance customers, where the payouts are paid further down the line as claims are made.
Berkshire Hathaway now reports a massive $123bn in float. As its insurance companies almost invariably make underwriting profits – rather than relying on the returns from investing float to compensate for their poor insurance practices – Buffett considers this float to be effectively costless.
Getting an interest-free loan of $123bn is going to be good for anyone’s returns!
Of course insurance is a heavily regulated industry – and Buffett himself is obsessed with downside protection, anyway – so there are limits to how he deploys this float.
But there’s no doubt it has enhanced Berkshire Hathaway’s returns over the years.
Just say no to debt
So Buffett does make use of performance-enhancing leverage, even if it’s not technically debt. But unless you fancy setting yourself up as a winner in the super-competitive insurance industry, cost-less float is not something that you or I can replicate at home.
I think it’s better to concentrate on saving hard, tucking your money away in tax shelters such as ISAs and SIPPs, and to forget about using debt when you invest.
It may take you longer to get to your goal than with a fortunate injection of debt – but you don’t want to be the person who gets it wrong and destroys their financial future!
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Owain Bennallack has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.