Warren Buffett On The Dangers Of Debt

A few days back, I wrote about where I thought interest rates might end up and how low leverage in the companies an investor invests in can help protect his portfolio.

In the article, titled Where Will Interest Rates Be?,  I also wrote about how the total debt to equity (TDE) ratio for the Straits Times Index (SGX: ^STI) currently stands at 78%.

The TDE ratio for the STI as a whole isn’t dangerously high but if we drill down a little deeper, we find, perhaps not surprisingly, that there’s quite a wide range in terms of the amount of leverage taken on by the index’s constituents.

The TDE ratio ranged from zero (or effectively zero) for Singapore Exchange (SGX: S68) and SIA Engineering (SGX: S59), to figures as high as 828%, 218% and 166% for Starhub (SGX: CC3), Wilmar International (SGX: F34) and Noble Group (SGX: N21) respectively.

While the presence of large amounts of debt in relation to cash on hand or equity for some of the blue chips isn’t necessarily a sign of irresponsible risk taking on the part of management, it’s still something that investors should keep their eye on.

I argued in Where Will Interest Rates Be? that “if interest rates rise, [companies with higher leverage] might be suffering the most and if interest rates remain stagnant or even fall, these companies still face large financial risks as credit markets (i.e. the accessibility to debt) can freeze in a relatively short span of time as seen during the Great Financial Crisis of 2007-2009.

In American billionaire investor Warren Buffett’s 2010 Berkshire Hathaway (an American conglomerate controlled by Buffett) shareholder letter, he wrote a few paragraphs to detail the dangers of using excessive amounts of borrowed money for both individuals and companies.

It’s very apt for what I was discussing in Where Will Interest Rates Be? and is in itself, a great lesson for investors that can also serve as a warning of sorts to not take the availability of debt for granted.

Here’s what Buffett has to say (emphasis his):

“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.

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.”

I only wished that I had managed to find this nugget of great wisdom from Buffett a few days back when I wrote Where Will Interest Rates Be? But as they say, it’s better late than never.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing owns B-Class shares of Berkshire Hathaway.