Tuesday, January 24, 2012

Buffett on Life & Debt

From the "Life and Debt" section of Warren Buffett's 2010 Berkshire Hathaway (BRKa) shareholder letter:

The fundamental principle of auto racing is that to finish first, you must first finish. That dictum is equally applicable to business and guides our every action at Berkshire.

Unquestionably, some people have become very rich through the use of borrowed money. However, that's also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you're clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.

Leverage, of course, can be lethal to businesses as well. Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally, though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job.

Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that's all that is noticed. Even a short absence of credit can bring a company to its knees. In September 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close to bringing our entire country to its knees.

Charlie and I have no interest in any activity that could pose the slightest threat to Berkshire's wellbeing. (With our having a combined age of 167, starting over is not on our bucket list.) We are forever conscious of the fact that you, our partners, have entrusted us with what in many cases is a major portion of your savings. In addition, important philanthropy is dependent on our prudence. Finally, many disabled victims of accidents caused by our insureds are counting on us to deliver sums payable decades from now. It would be irresponsible for us to risk what all these constituencies need just to pursue a few points of extra return.

Later in the letter Buffett added:

By being so cautious in respect to leverage, we penalize our returns by a minor amount. Having loads of liquidity, though, lets us sleep well. Moreover, during the episodes of financial chaos that occasionally erupt in our economy, we will be equipped both financially and emotionally to play offense while others scramble for survival. That's what allowed us to invest $15.6 billion in 25 days of panic following the Lehman bankruptcy in 2008.

In a recent post, I highlighted the advantage that Wells Fargo (WFC) and U.S. Bancorp (USB) have over some other banks in terms of net interest margin. Simplifying things greatly, both banks obtain a superior spread between the cost of its funds (cheap deposits) and what they're paid for the money that it loans to customers. Still, like any bank, they must employ substantial leverage to generate above average returns.

Berkshire is ultimately also profiting from the spread between cost of funds (mostly its substantial insurance float) and what it does with that money. So it's similar to a bank in that respect. Yet, the way Berkshire goes about making above average long-term returns is very different. What's the main difference? Again, simplifying things a bit, Berkshire employs modest leverage but makes up for it via the extreme "spread"  between its low cost (actually, in some years better than no cost) float and the assets it invests in.*

So Berkshire doesn't need the multiplier of leverage (and, since leverage cuts both ways, nor is it exposed to the downside risk).

"Leverage is the only way a smart guy can go broke." - Warren Buffett on The Charlie Rose Show

Paying nearly nothing for money and buying businesses that often generate a return in the teens is a good way to make a living.

Sounds easy but, of course, it is not.

"The businesses that Berkshire has acquired will return 13% pre-tax on what we paid for them, maybe more. With a cost of capital of 3% -- generated via other peoples' money in the form of float -- that's a hell of a business. - Charlie Munger at the 2001 Wesco Annual Meeting

So these days a good bank might get a 4% spread between what it pays for deposits and the various loans it makes.

Through smart capital allocation, Berkshire can produce 2 to 3 times or more than that spread while using little leverage.

Berkshire is set up to produce an extreme spread between cost of funds and the returns it gets on investments. The result: the company is capable of generating high returns without the need for the kind of leverage that is involved in banking.


Long position in BRKb established at lower prices

* Primarily good businesses (or shares of good businesses), preferred shares, and a sizable bond portfolio.
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