Two investors I admire, Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio), have recommended that to learn about investing, investors should read Berkshire Hathaway Inc's (BRK.A, BRK.B) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, I cover the 2005 letter.
Berkshire's Approach to Debt
In the 2005 shareholder letter, Buffett says that Berkshire, except for token amounts, typically shuns debt except for three reasons. Occasionally using repos as a part of certain short-term investing strategies that incorporate ownership of U.S. government (or agency) securities. These purchases are highly opportunistic and involve only the most liquid of securities. A repo is when a dealer sells government securities to an investor, usually on a short-term basis, and buys them back soon at a slightly higher price.
Secondly, Berkshire sometimes borrows money against a portfolio of interest-bearing receivables whose risk characteristics Berkshire understands. Alternatively, Berkshire sometimes “securitizes” – that is, sell – these receivables, but retain the servicing of them.
Debt in Portfolio Companies
Then at portfolio companies, such as at MidAmerican, Berkshire can have substantial debt, but it is that portfolio company’s obligation only. Though it appears on Berkshire’s consolidated balance sheet, Berkshire does not guarantee it. Even so, this debt is unquestionably secure because it is serviced by MidAmerican’s diversified stream of highly-stable utility earnings. Berkshire can take this risk because it is highly diversified so meaning that if one of this portfolio holding’s had problems, the returns from other holdings will help cover the problematic company’s debt requirements.
Understanding Risk
From a risk standpoint, it is far safer to have earnings from ten diverse and uncorrelated utility operations that cover interest charges by, say, a 2:1 ratio than it is to have far greater coverage provided by a single utility. A catastrophic event can render a single utility insolvent – witness what Katrina did to the local electric utility in New Orleans – no matter how conservative its debt policy. A geographical disaster – say, an earthquake in a Western state – can’t have the same effect on MidAmerican. And even a worrier like Charlie can’t think of an event that would systemically decrease utility earnings in any major way. Because of MidAmerican’s ever-widening diversity of regulated earnings, it will always utilize major amounts of debt.
Berkshire's Stance on Debt for Acquisitions
Otherwise, Buffett says Berkshire is not interested in taking on more debt for acquisitions or operating purposes. Buffett says he doesn’t mind going against conventional business wisdom and doesn’t mind giving up some extra profits that could be squeezed from higher leverage. Buffett says the reason is because many of Berkshire’s investors, (which includes the board members), would find it a disaster if Berkshire faced any serious problems. This coupled with Berkshire’s insurance liabilities where normal people are reliant on insurance payouts means that Buffett thinks that Berkshire can cope with all manner of “financial panics, stock-exchange closures (an extended one occurred in 1914) or even domestic nuclear, chemical or biological attacks.”
Lessons Learned and Investment Strategies
The lessons I learn from this are the investors can make good returns by being creative, and but that one must also be competent in the specific area of investment. Diversification helps offset risks, and not getting to incur a permanent impairment of capital helps longer run compound returns. George Soros (Trades, Portfolio) had a similar mentality in trading in that the number one priority was not to lose very much money on any single trade. Buffett is telling us we should try not to lose much money on any one investment, but by having a range of good investments, then bad luck can be compensated against.
Exploring Undervalued Markets
Also, by being creative, you can get returns from undervalued parts of the markets in different asset classes. This is similar to Joel Greenblatt (Trades, Portfolio)’s theory of special situations. If we only invest in well-known stocks, these will mostly likely be priced relatively efficiently, and we’ll struggle to generate market-beating returns. So while Buffett is generally against debt for the sake of leveraging up returns, he’s happy to invest in debt when the risk is compensated adequately by the returns, and importantly, it’s managed so that no catastrophic wipeout happens.
