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Warren Buffett: Life and Debt

- By Stepan Lavrouk

"The fundamental principle of auto racing is that to finish first, you must first finish. That dictum is equally applicable to business and guides our every action at Berkshire."

This quote by Warren Buffett (Trades, Portfolio) exemplifies perfectly the conservative approach to investing that has defined Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) over the last 50 years. Part of that approach has been an aversion to debt. One would think that one of the biggest companies in the world got that way through using at least some amount of leverage, but the reality is that Berkshire has almost never used debt to fund its acquisitions.

Berkshire's subsidiary companies may hold debt that appears on its consolidated balance sheet, but the holding company itself tends to stay away from it. In his 2010 letter to shareholders, Buffett expanded on why he and Charlie Munger (Trades, Portfolio) have chosen this policy.

Leverage is addictive

Buffett's main objection to leverage is twofold. First, he believes that once you start using it, it become very difficult to wean yourself off of it:

"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 neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices."

The second is that the use of debt can put a company in a position out of its own control. Ever since the 2008 financial crisis, and the era of ultra-low interest rates that came about as a result of it, U.S. corporate debt has ballooned considerably . Refinancing this debt may be easy if interest rates stay low, but would become considerably less so if they were hiked.

"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."

As a result, Berkshire holds a considerable amount of cash, around $114 billion. This enormous amount of financial dry powder gives Buffett and Munger the opportunity to act quickly when and if a big opportunity presents itself. In 2008, Berkshire was able to do this to great effect:

"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. That's what allowed us to invest $15.6 billion in 25 days of panic following the Lehman bankruptcy in 2008."

Buffett has recently spoken of his desire to make an "elephant-sized acquisition." Being debt-free will certainly allow him to do so.

Disclosure: The author owns no stocks mentioned.

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This article first appeared on GuruFocus.