How Berkshire Hathaway Got Bigger by Getting Better (Part Four)

By Matthew DiLallo - July 10, 2012 | Tickers: BAC, BRK-B, BAM, CHK, JPM | 0 Comments

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In the third part of an ongoing saga loosely based on a story inspired by Chick-fil-A founder Truett Cathy I went through two additional principles from Warren Buffett’s “Owner’s Manual” for Berkshire Hathaway (NYSE: BRK-B) shareholders. If you haven’t heard the story yet, back in the 1980’s when a Boston Chicken (now Boston Market) had just finished raising capital to expand; the management at Chick-fil-A spent a long time discussing how they too could get bigger in order to fend off this threat. After hearing enough talk about getting bigger, Cathy pounded the table and said, “I am sick and tired of listening to you talk about how we can get bigger. If we get better, our customers will demand we get bigger.” With few better case studies on management out there than Warren Buffett, we’re sure to become better investors by listening to his words of wisdom.

Principle #7:

“We use debt sparingly and, when we do borrow, we attempt to structure our loans on a long-term fixed-rate basis. We will reject interesting opportunities rather than over-leverage our balance sheet. This conservatism has penalized our results but it is the only behavior that leaves us comfortable, considering our fiduciary obligations to policyholders, lenders and the many equity holders who have committed unusually large portions of their net worth to our care. (As one of the Indianapolis “500” winners said: “To finish first, you must first finish.”)”

Of all the principles we’ve looked at thus far, disregard of this one causes more trouble than the promised returns are worth.  Complete indifference of the dangers of debt cannot be overlooked.  The problems in Europe and our own fiscal cliff here in the US are both prime examples of how debt can have a crippling effect to more than just those who fall prey to its promise.

Debt can take away a company’s flexibility at a time when flexibility is crucial.  It takes away control as covenants come into play.  These covenants put restrictions on a borrower and if those covenants are broken the loan can become due immediately, usually at the worst possible moment because sinking sales or squeezed profits have already put a drain on available cash.  More often than not bankruptcy is a result of a liquidity crisis brought on by restricted access to external debt financing than from solvency concerns.

Buffett is rather open about the fact that their sparing use of debt will penalize results.  While a rather simplistic example but consider this, if you have $1,000 to invest and can get a 5% return you’ll make 50 bucks.  However, if you can borrow another $1000 at 1% and then invest that alongside your own $1,000 you’ve now juiced your earnings to $90.  Such is the allure of using leverage and it can work out beautiful, when it is working.  It is those long sleepless nights when you have to find a way to pay back the debt because your “safe” investment turned out to be quite the opposite that Buffett would rather avoid.  Too many companies have left investors feeling uncomfortable by their abuse of debt.

We saw the sting of debt throughout the housing turned financial crisis.  Homeowners bought more house than they could reasonably afford and banks loaned out more money than they should have conservatively lent.  As that crisis rippled through our great nation, the over levered balance sheets at financial institutions like Country Wide and Bear Sterns forced their executives to sell their firms for fractions of their former value to their more well capitalized rivals, Bank of America (NYSE: BAC) and JP Morgan Chase (NYSE: JPM) respectively. 

While banks have gotten a lot of press for their overzealous use of leverage, they are not alone in its abuse.  Many other public companies fall prey to the allure of debt especially when they have the opportunity to acquire a competitor or expand more rapidly.  I’ve been following the leverage at Chesapeake Energy (NYSE: CHK) and while CEO Aubrey McClendon could eventually come out to be viewed as a brilliant visionary for his role in the future of natural gas, yet, the leverage employed to get there is causing much concern for his investors.  Back before the financial crisis he personally loaded up on margin debt to buy his company’s stock which had disastrous results.  He’s continued to saddle the company with more than $10 billion in debt to fund the company’s land acquisition and drilling programs.  This is one of those instances where Buffett’s quip, “To finish first, you must first finish,” really becomes relevant.

Debt can be a crucial piece of a public company’s capital structure.  It just must be used appropriately and Buffett even mentions that it is an important consideration for the utility and railroad businesses that Berkshire owns.  In the owner’s manual he drills down a bit on this subject and said that while they favor long-term, fixed rate loans they also plan those loans to be non-recourse to Berkshire.  In the event that some unforeseen event caused a liquidity crisis at one of their businesses, the whole firm would not be put at risk.

This type of financing is employed by the management team at Brookfield Asset Management (NYSE: BAM).  Often considered as a mini-Berkshire, this fantastic management team will seeks out companies who’ve fallen prey to the dangers of debt, as they’ve assisted in the recapitalization or outright acquisition of dozens of companies over the years at deeply discounted values.   They’ll then use long term, fixed rate, non-recourse financing to appropriately capitalize an asset and then enjoy decades of steady returns.  Liquidity driven flexibility as part of smart management of the capital structure can become a tremendous competitive advantage, especially during the tough times. 

Management teams have a knack for using debt to check off item’s from their “wish list” as they build their empire at the expense of shareholders.  In Part V we’ll take a look at this eighth principle which continues to vastly under deliver its promised synergistic increase of shareholder value.

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