Hello, I am Nicolas Bustamante, and each week, I write about concepts and methods to build successful businesses.
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Leverage usually refers to the use of debt to amplify returns from an investment. Debt is a great instrument that allows multiplying one's purchasing power. Ideally, one can borrow money at a definite price, invest and then reimburse the debt while keeping the difference in value. Unfortunately, leverage is highly addictive, and it enhances gains as well as losses.
Warren Buffet, along with most Intelligent CEOs, is skeptical of leverage. He wrote: "Over the years, a number of very smart people have learned the hard way that a long string of impressive numbers multiplied by a single zero always equals zero. That is not an equation whose effects I would like to experience personally, and I would like even less to be responsible for imposing its penalties upon others." It's typical reasoning of value investors who understand that the key to winning is first to survive. It means that no extra returns are justifiable if the principal is in danger of dramatic loss.
Leverage is addictive. It magnifies your gain, and when the operation is successful, one has the temptation to take on more debt. Quoting Buffet: "When leverage works, it magnifies your gains. Your spouse thinks you're clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices." Like all addictions, it's hard to stop until it's too late.
The logical conclusion is to aim at building a sound financial structure. Great companies with terrific moats but bad balance sheets die too often. A strong balance sheet provides the necessary margin of safety to be successful. I recommend having enough cash on hand, net of debt, to cover six months' worth of operating expenses - calculated using a rolling 12 months average. As Intelligent CEO Joe Mansueto from Morning Star wrote in the aftermath of 2008: "We want to make sure Morningstar will survive and prosper for a long time. Like most everyone, I was stunned last year when large, well-known firms suddenly disappeared. It's a great lesson in the value of maintaining a conservative approach, sticking to fundamentals, and avoiding complex situations even if everyone else is embracing them."
I love this approach because it allows the Intelligent CEOs to play prudently when others are greedy and play aggressively when everyone is retreating. Life is uncertain and extreme events shape our world. Holding significant liquidity with limited debt creates optionality and is essential first to survive and second to buy low during crashes. Warren Buffet wrote: "By being so cautious in respect to leverage, we penalize our returns by a minor amount. Having loads of liquidity, though, lets us sleep well. Moreover, during the episodes of financial chaos that occasionally erupt in our economy, we will be equipped both financially and emotionally to play offense while others scramble for survival." Berkshire Hathaway invested $15.6 billion in the 25 days of panic following the Lehman bankruptcy in 2008. That's what I like, conservative yet super bold!
To sum up, debt is a good but addictive instrument. Maintaining a conservative balance sheet is a necessary condition to last and win. An Intelligent CEO should thrive on earning good returns on equity while employing little or no debt!
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