Wednesday, April 20, 2011

Buffett on Debt: Berkshire Shareholder Letter Highlights

"Our basic principle is that if you want to shoot rare, fast-moving elephants, you should always carry a loaded gun." - Warren Buffett in the 1987 Berkshire Hathaway (BRKa) Shareholder Letter

Written over two decades ago, the above quote is not unlike the recent "our elephant gun has been reloaded, and my trigger finger is itchy" comment by Warren Buffett that received plenty of press after the release of the 2010 Berkshire Hathaway shareholder letter.

Though similar, the earlier quote is used in the context of how and when debt should be used to finance acquisitions. From the 1987 Berkshire Hathaway shareholder letter:

"To be sure, it is likely that Berkshire could improve its return on equity by moving to a much higher, though still conventional, debt-to-business-value ratio. It's even more likely that we could handle such a ratio, without problems, under economic conditions far worse than any that have prevailed since the early 1930s.

But we do not wish it to be only likely that we can meet our obligations; we wish that to be certain. Thus we adhere to policies - both in regard to debt and all other matters - that will allow us to achieve acceptable long-term results under extraordinarily adverse conditions, rather than optimal results under a normal range of conditions.

Good business or investment decisions will eventually produce quite satisfactory economic results, with no aid from leverage. Therefore, it seems to us to be both foolish and improper to risk what is important (including, necessarily, the welfare of innocent bystanders such as policyholders and employees) for some extra returns that are relatively unimportant. This view is not the product of either our advancing age or prosperity: Our opinions about debt have remained constant.

However, we are not phobic about borrowing. (We're far from believing that there is no fate worse than debt.) We are willing to borrow an amount that we believe - on a worst-case basis - will pose no threat to Berkshire's well-being. Analyzing what that amount might be, we can look to some important strengths that would serve us well if major problems should engulf our economy: Berkshire's earnings come from many diverse and well-entrenched businesses; these businesses seldom require much capital investment; what debt we have is structured well; and we maintain major holdings of liquid assets. Clearly, we could be comfortable with a higher debt-to-business-value ratio than we now have.

One further aspect of our debt policy deserves comment: Unlike many in the business world, we prefer to finance in anticipation of need rather than in reaction to it. A business obtains the best financial results possible by managing both sides of its balance sheet well. This means obtaining the highest-possible return on assets and the lowest-possible cost on liabilities. It would be convenient if opportunities for intelligent action on both fronts coincided. However, reason tells us that just the opposite is likely to be the case: Tight money conditions, which translate into high costs for liabilities, will create the best opportunities for acquisitions, and cheap money will cause assets to be bid to the sky. Our conclusion: Action on the liability side should sometimes be taken independent of any action on the asset side.

Alas, what is 'tight' and 'cheap' money is far from clear at any particular time. We have no ability to forecast interest rates and - maintaining our usual open-minded spirit - believe that no one else can. Therefore, we simply borrow when conditions seem non-oppressive and hope that we will later find intelligent expansion or acquisition opportunities, which - as we have said - are most likely to pop up when conditions in the debt market are clearly oppressive. Our basic principle is that if you want to shoot rare, fast-moving elephants, you should always carry a loaded gun.

Our fund-first, buy-or-expand-later policy almost always penalizes near-term earnings."

So use of debt is fine if it doesn't pose risk to the franchise.

Borrow in anticipation of needs not in reaction to needs.

Obtain debt when borrowing conditions seem loose.

Acquire businesses when borrowing (tight borrowing conditions = fewer competing bidders) becomes tight.

The better banks should be in the process of doing something similar, the difference being that unlike Berkshire they are not in the business of using their liabilities (predominantly deposits) to acquire businesses but instead to acquire profitable loans.

Berkshire Hathaway:
Uses liabilities (insurance float, other sources of borrowing) to acquire assets (profitable businesses).

Uses liabilities (predominantly deposits) to acquire assets (loans, bonds etc.).

Some seem disappointed that the loan growth for banks has not begun in earnest. Buffett's model above suggests the smart ones should pursue loan growth more cautiously. While still in the process of cleaning up the junkier balance sheet assets acquired in the last cycle, banks should be focused on borrowing as cheaply as possible* (ie. building a larger base of stable, cheap deposits) now in anticipation of acquiring quality profitable loans later.

 I think today's earnings release from Wells Fargo (WFC) is further evidence that loan growth is not going to happen (and shouldn't) just yet.  In fact, it might be wise to shrink a bit first (slowly get rid of or burn off the poor quality stuff). The loan growth part of the cycle is still ahead of them and there is no rush.

I'll take slower, profitable growth any day.


Long BRKb and WFC

* For banks this means acquiring cheap least cheap relative to other banks. When short-term rates start to rise so will the cost of deposits for all banks. The key is being able to establish a relatively lower cost deposit base than your competitors. Some banks clearly do this better than others and gain an enormous advantage (ie. higher ROE) over a complete business cycle.
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