Investment Strategy

The Dangers of Debt

In early 2012 Eike Batista, a Brazilian, was the seventh richest man in the world. He had a reported fortune of $30 billion built in the mining and oil & gas businesses. He has now lost almost all of that wealth mountain. The reason? Massive amounts of debt. There are many dangers of debt, and all investors need to be aware of them.

Warren Buffett, the Chairman and CEO of Berkshire Hathaway and a famous value investor, is another billionaire. He was ranked the world’s richest man in 2008, and is still in the top few. But Buffett uses very little debt in his businesses.

In fact quite the opposite. He tends to hold large amounts of positive net cash, meaning he has “liquidity” at all times. Here’s a quote from his 2013 letter to Berkshire Hathaway shareholders, something I recommend that all OfWealthers take the time to read. (“Charlie” is Charlie Munger, his long time business partner.)

“Charlie and I believe in operating with many redundant layers of liquidity, and we avoid any sort of obligation that could drain our cash in a material way. That reduces our returns in 99 years out of 100. But we will survive in the 100th while many others fail. And we will sleep well in all 100.”

Buffett may have taken longer to make his fortune than Batista. But his high cash levels and low debt levels mean he will keep his billions.

Debt is all around us these days. Government policies in the developed countries suppress interest rates. The idea is to keep interest costs down for government, businesses and individual people (voters). But cheap debt encourages people to have more and more of it.

…policies aimed at solving those problems result in even more debt. Debt has driven the world insane.

Excessive debt created a lot of the world’s problems. But the policies aimed at solving those problems result in even more debt. Debt has driven the world insane.

One day interest rates will rise, and keep rising. Usually this process takes decades, in the same way that rates have been falling in the USA since 1981. These are slow cycles.

But when it happens we should expect all hell to break loose. Governments will find much bigger portions of their spending budgets directed to paying interest on government bonds. Mortgages with variable interest rates will decimate family budgets. Corporate profits will collapse, and bankruptcies will follow.

This is why governments will do everything they can to prevent this from happening. In the meantime the problem gets bigger. One day governments will lose control, and the price will have to be paid.

According to Marc Faber, author of the Gloom, Boom and Doom report (and one of my favourite investment commentators), interest costs in US non-financial corporations, as a percentage of pre-tax profits, went ballistic during the last period when interest rates rose. Between 1965 and 1982 they went from 10% of profits to 60% of profits.

Although I don’t have direct evidence, it’s my bet that US companies have a lot more debt in 2013 than they had in 1965, relative to assets and profits.

If rates start going up we could see carnage in US corporate profits, and of course in the US stock market. There would be a wave of bankruptcies and job losses. But the US is not alone. Debt is cheap, and therefore plentiful, in Europe as well.

On top of this, there’s a huge amount of debt fuelled speculation going on in the US stock market itself. As I’ve explained before, US margin debt is at record levels in relation to the size of the stock market (the market capitalisation).

Margin debt is money borrowed to speculate on markets. It’s a highly risky form of debt, since if share (stock) prices fall suddenly then there will be a “margin call”, meaning some of the debt must be repaid immediately. This creates forced sellers, creating a vicious downward spiral of falling prices and more forced selling.

Of course we all need debt from time to time. In most countries it’s impossible to buy a home without having a mortgage. It would simply take too long for most people to save up all the money required.

And it can make sense for companies to have modest amounts of debt, provided the funds are invested wisely in productive assets or business expansion. Unfortunately a great many companies take on too much debt, and use it for unproductive purposes such as buying back stock, and eventually go bust.

On a personal level it also takes away freedom… You become a slave to your debt.

But most debt is best avoided. It’s expensive and increases risk. On a personal level it also takes away freedom. If you have massive personal debts then it’s harder to take career risks, or just to quit a job that you hate. You become a slave to your debt.

It’s better to be a Buffett than a Batista if you want your wealth to grow and survive. However it’s not enough just to control your own debt levels. When you’re investing you need to know what others are up to as well.

The Dangers of Debt

Is a foreign government borrowing too much, putting its currency at risk of a fall, in turn making shares and bonds in that country more risky?

Does a company have more debt than it can safely pay for, meaning its shares should be avoided?

Are stocks being driven up to unsustainable levels by debt fuelled speculators that use margin loans, meaning there’s a risk of a crash?

Has your bank leveraged up its balance sheet, exposing it to bankruptcy and increasing the chance that you won’t be able to withdraw your deposits in the future?

These are just some of the questions all of us need to ask when saving and investing. Remember fellow OfWealther, the dangers of debt are lurking all around us. Watch out!

Stay tuned OfWealthers,

Rob Marstrand

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.