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Lessons from Warren Buffett - LXI
Nov 10, 2015

Our last article focussed on the lessons from Buffett's 2009 letter to shareholders. We looked at the businesses one should avoid when investing and examined the significance of liquidity.

With those lessons in mind, we now move on to Buffett's 2010 letter. Here Warren Buffett details the dangers of excessive borrowing. The message is for individuals as well as businesses.

To drive home his point, Buffett wrote:

  • 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 neighbours 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.

This is true. High debt can drain years of accumulated wealth. And the problem becomes worse if you are addicted to borrowing and believe that's the only way to maximise gains.

As the gains from borrowed money begin to accumulate, many investors get fooled. They fall into the trap and borrow more money with the false expectation the gains will continue. But nothing could be further from the truth. Banking on borrowed money is a one-way ticket to hell, as the 2008 global credit crisis demonstrated.

Because at some point, you have to repay that debt. And as the debt keeps piling on, the ability to repay only becomes harder, and you end up borrowing more to repay the existing debt. It's a vicious cycle.

According to Buffett,'It's not debt per say that overwhelms an individual, corporation, or country. Rather, it is a continuous increase in debt in relation to income that causes trouble.'

Again, it's not only individuals or households at risk. Buffett explaines how businesses also get trapped in the debt cycle:

  • 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.

Companies employ leverage to generate higher returns on their assets. However, using leverage does not always work. In an economic boom, all is hunky dory. But when there is a downturn (and there is always a downturn in an economic cycle), highly leveraged companies will struggle to make profits. Sales slow and margins shrink, but interest on debt has to be paid. And this eats into net profits. In worse cases, companies are compelled to sell some assets and use the cash to ease the debt burden.

Buffett concludes:

  • 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.

He is referring to the infamous Lehman crisis here. Lehman's bankruptcy filing was the largest in history, as the firm had US$639 billion in assets and US$619 billion in debt. On September 15, 2008, Lehman Brothers filed for bankruptcy, a decisive event that greatly intensified the 2008 crisis and contributed to the erosion of close to US$10 trillion from global equity market capitalisation in October 2008.

The lesson here is simple: stay away from excess debt. And when investing, filter out companies that have excessive debt on their books. As Buffett has said:

  • I do not like debt and do not like to invest in companies that have too much debt, particularly long-term debt. With long-term debt, increases in interest rates can drastically affect company profits and make future cash flows less predictable.

Rahul Shah

Rahul Shah (Research Analyst), Managing Editor, Microcap Millionaires has led the team from the front in developing some of our most stringent and rewarding research processes. As per his own admission, the turning point in Rahul's life as a financial analyst came a few years back when he got introduced to the works of Warren Buffett and Charlie Munger. From Buffett, he understood the value of investing in good quality business with powerful moats and strong management teams. Charlie Munger on the other hand inspired him to be a lifelong learner and use mental models in order to arrive at the crux of matters across most disciplines. Rahul firmly believes that in order to be successful at investing, you have to do the big things right and possess a great temperament and a contrarian streak.

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1 Responses to "Lessons from Warren Buffett - LXI"

Rajendra Chauhan

Nov 11, 2015

Sir, I learn from you day to day growth in my routine life







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