Thread by @flaneur_a

(1/19)

Leverage & Buffett:
In the investor circle, one of the key criteria for scouting a good company is "zero debt". And why not, after all over leverage is a leading cause of corporate ruin.
Let's step back and analyse this...

Right since the discovery of the wheel to all the gadgets we use today, mankind has used leverage. Financial leverage is just a subset of this.

A leverage is a force multiplier that gives either:
1) efficiency, by enhancing the output or,
2) convenience, by reducing the toil

(3/19)

However, as Aristotle said,
"Any vice carried to an extreme is a vice."
A car is a great leverage, but over-speeding causes accidents. This does not mean that we abandon car and set off from Mumbai to Pune afoot.

I wrote about this in this article/Twitter Thread...

https://twitter.com/flaneur_a/status/1298586997578018817

I wish to elaborate this further by quoting some excerpts from Chapter 6 (The use of debt by Berkshire Hathaway) of the book:

The Warren Buffett Philosophy of Investment - Elena Chirkova

"Although Buffett’s views on borrowing may suggest otherwise, Berkshire’s level of leverage cannot be regarded as very low. As estimated by Andrea Frazzini, David Kabiller, and Lasse Pedersen, the share of leverage in Berkshire’s capital structure amounted on average

to approximately 37.5% from 1976 to were not using leverage with great skill. It is precisely the use of leverage that is one of the key components of his phenomenal success. The bulk of Berkshire’s borrowing takes place.... through writing insurance policies.

(8/19)

"In Frazzini, Kabiller, and Pedersen [2012, p. 7] it is estimated that insurance premiums represent on average 36 percent of the liabilities of Berkshire Hathaway."

Here are two quotes from Warren Buffett:
"Float is wonderful."
"The business is a lemon if its cost of float is higher than market rates for money."

(10/19)

What separates a good leverage from bad?
In my article, I've explained two key characteristics of good leverage:
1) (Return on Assets) > (Cost of Liabilities)

Berkshire picked insurance business at very low rates. He also timed picking his liabilities. He refused insurance business so many times, while went aggressive other times.

"Pulling away from the market in difficult years is encouraged by the company’s employee compensation schemes. Senior managers are compensated on the basis of the return on capital that they deliver...

(13/19)

...The rest of the employees in Berkshire Hathaway’s insurance companies are not motivated to grow the business at any cost because they are not afraid of being fired during tougher times.

2) Assets should generate funds before the loan (liability) outflow is due.
The liabilities & their outflow should be due after the assets & their inflows. The Insurance float is all long term nature.

Buffett even indulged in long dated put option selling to earn premium...and actually ran into some short term trouble.

This smart leveraging, as the author of the book, The Warren Buffet Philosophy of Investment, Elena Chirova, claims, played a big part in Buffett's success.

(17/19)

Time to summarise:
Leverage is not bad, over & excessive leverage is. Leverage is an integral part of success of humans. It needs to be used effectively.
Good Leverage - Long Term, low cost (lower than assets returns) and easy reversibility (like a brake in the car!)

Please read my article, if you're still curious...

rationalflaneur.com/leverage-a-dou…

*Any virtue carried to an extreme is a vice.