At a Berkshire Hathaway (BRK-B) annual meeting I attended in the 1990s, Warren Buffett said he only had one skill…
It was the ability to allocate capital.
Now, you might think that process would be straightforward. But as I explained recently, Buffett’s decision-making prowess often breaks with common assumptions.
Today, we’re going to look at another one of those breaks…
You’ll see that this essay is all about debt. More specifically, we’ll cover how sensible allocation between two types of capital – equity and debt – can boost a company’s returns…
Think of debt as “fire”…
Left uncontrolled, a fire can destroy and kill. But humanity learned eons ago how to control fire – and to harness its power. Likewise, we can harness the power of debt to make things better.
Consider your personal life… Mortgage loans allow you to buy a bigger, better home than you could get if you just paid cash.
Business owners can “leverage up” by taking on debt, too. They can light a fire under their business.
As long as it’s taken care of, that fire can stoke the company’s returns. But if it’s left uncontrolled, it will burn the company to the ground.
That’s why leveraging up isn’t for all companies.
Simply put, debt means interest payments. And the company must make those payments even when business temporarily turns down. If not, too bad… It’s pay up – or else.
In most cases, “or else” means bankruptcy. Other times, debtors linger as “zombie” companies. Either outcome is bad news for shareholders.
So leveraging up is only for two kinds of companies…
It’s for the companies consistently making enough money every year to pay their interest. Or it’s for the companies that make enough in good years to save for a “rainy day.” By that, we mean a down year in which the company doesn’t earn as much as it needs to pay interest.
Here’s where Warren Buffett’s trick comes in…
He’s not afraid to invest in companies with a lot of debt.But most importantly… Buffett tends to buy companies that can easily make the interest payments on their debt.
In short, when Buffett invests Berkshire Hathaway’s funds into other public companies, he’s willing to choose businesses that can productively handle their debt…
The median long-term debt-to-equity ratio among companies in which Berkshire Hathaway holds large stakes is roughly 1.6. In comparison, the median long-term debt-to-equity ratio of the S&P 500 Index is around 0.7 today.
And the median interest-coverage ratio – which measures the availability of operating profit for use in paying interest – is 13.1 for Berkshire Hathaway. For the S&P 500, it’s 10.4.
So we can see that companies in Berkshire Hathaway’s portfolio can afford to service their debt. Now, let’s see if using debt lets these companies boost their returns beyond what they could’ve achieved without borrowing…
For that, we’ll look at return on assets (“ROA”). This metric shows what a company earns on all of its capital. It’s comparable to “how much house” you get for the price you pay (down payment plus mortgage debt).
The five-year median ROA for Berkshire Hathaway’s large holdings is 3%. That’s less than the S&P 500’s 5.6% for this metric.
But don’t jump to a negative conclusion…
Return on equity (“ROE”) is another measure of profitability. It shows how much the company earned only from the owners’ equity. This is comparable to “how much house” you would get for only the down payment.
In short, using mortgage debt wisely allows a homebuyer to get a lot more house than would be possible from the down payment alone.
Something just like that happened with the companies in which Berkshire Hathaway has large investments… Their wisely used, affordable debt pushed the five-year median ROE for these holdings up to 25.1% versus 14.3% for the S&P 500.
Folks, this is as clear as it gets in finance…
Buffett, the king of value investing, doesn’t mind buying companies with high debt loads. But he makes darn sure those companies can pay their bills. And he makes sure their management teams are capable of effectively using the capital raised by the debt.
So in the end… don’t shy away from debt in the markets. Just make sure the fire is under control. You don’t want it to burn the house down.
Good investing,
Marc Gerstein
