LUMN - Buffett's Warning Of How Smart People Go Broke And Dividend Investing

2024-01-10 11:36:28 ET

Summary

• Warren Buffett once discussed the only way that a smart person could go broke.
• We discuss the investing ramifications of this.
• We also apply Warren Buffett's wisdom to the art of dividend investing.

Berkshire Hathaway's ( BRK.A , BRK.B ) Warren Buffett once opined :

There's only three ways that a smart person can go broke…liquor, ladies, and leverage.

In this article, we will discuss the third of these three paths to failure that can on occasion ensnare even the highest IQs and then share how Buffett's wisdom applies to dividend investing.

Why Leverage Destroys Even The Smartest Investors

Leverage can be very seductive to even the most intelligent investors due to its promise of amplified returns. After all, if an investor supplements a $100,000 investment of their capital with an additional $100,000 of borrowed funds, total returns on their own equity double (minus whatever the cost of those borrowed funds is) when stock prices rise.

During boom periods such as this past year when the S&P 500 (SP500) and Nasdaq ( QQQ ) soared higher thanks to the tremendous performance rendered by the so-called "Magnificent Seven" ((Apple ( AAPL ), Amazon ( AMZN ), Alphabet ( GOOG , GOOGL ), Meta ( META ), Nvidia ( NVDA ), Microsoft ( MSFT ), and Tesla ( TSLA )), it can be particularly tempting to further amplify those gains with borrowed funds. This is because - when stock prices rise day after day (and on some days they jump a lot) - it can be easy to become complacent and forget that stocks can drop just as quickly as they rise and fall into an extended losing streak just as easily as they achieve a winning streak. As a result, even the smartest individuals often fall prey to the promise of quick riches by investing in stocks with significant sums of borrowed money.

Moreover, many business owners also fall prey to this same temptation as they see how applying leverage to their businesses can significantly juice their returns on equity. This condition is quite prevalent across many sectors of the U.S. economy, especially after such an extended period of historically low interest rates. Many companies borrowed large sums of money and used it to either fuel rapid growth or aggressive stock buybacks.

However, as Warren Buffett points out, the use of leverage is fraught with danger, especially when used in large quantities. As he once stated :

You really don't need leverage in this world much. If you're smart, you're going to make a lot of money without borrowing

Moreover, if you get greedy and are no longer content with the remarkable long-term compounding that debt-free (or at least very prudently leveraged) investing can generate for you, you can instead set yourself up for catastrophic failure and potentially even go bankrupt.

The reason why leverage can be so destructive to long-term wealth accumulation is because compounding, in its purest form, works exponentially over time, steadily multiplying wealth. However, when leverage is introduced into the equation, the risks are amplified alongside the potential gains. As a result, when markets crash and/or business expectations fail to come to fruition, leverage can potentially multiply your principal by zero, effectively wiping out all of your money accumulated up to that point.

This would then reset your financial journey back to square one, erasing all the gains that could have been compounded over time and effectively wasting years of hard work, careful saving, and skillful investing. This contrasts sharply with the steady, exponential growth of a well-managed, unleveraged investment portfolio. While leverage might offer the allure of quick gains, it undermines the fundamental principle of long-term investing: the consistent, exponential accumulation of wealth over time through the power of compounding. In essence, leveraging can turn a marathon with a predictable positive outcome into a risky binary sprint, where the potential for a sudden reversion back to zero is quite possible. The upside is wealth, but the downside is potential poverty and the forfeiture of what would have otherwise been a high probability of achieving financial independence. As Warren Buffett once stated :

It's insane to risk what you have and need for something you don't really need.

Applying The Lesson To Dividend Investing

Warren Buffett's cautionary words on leverage also apply to dividend investors, particularly regarding dividend sustainability. Just as leverage can enhance total returns, it can also enhance dividend income by increasing the cash flow yield on investments whenever the cost of the leverage is less than the yield of the asset being invested in. However, once again, leverage can cut both ways here as it can significantly undermine the stability and growth of a company's dividend. Companies that are excessively reliant on debt may face challenges in maintaining or increasing dividends as periods of economic distress and/or business underperformance may force management to slash its payout to focus on fortifying its balance sheet.

Sadly, the dividend stock sector is filled with countless tragic cases of this taking place. Recent examples of this include:

• Energy Transfer ( ET ) halved its distribution back in 2020 in the wake of the COVID-19 outbreak and the steep decline in energy prices that followed. Its narrowly held investment grade credit rating of BBB- was on the verge of getting downgraded, so management made the hard decision of reducing its distribution in order to accelerate debt reduction. This contrasted sharply with more prudently financed peers like Enbridge ( ENB ) who were able to continue growing their payouts through the COVID-19 outbreak because they did not overleverage their balance sheets in pursuit of higher returns.
• Algonquin Power & Utilities ( AQN ) leveraged up its balance sheet with debt - including floating rate debt - to pursue its ambitious growth strategy. As a result, when interest rates suddenly spiked over the past few years, it was caught off guard and had to slash its dividend to preserve its investment-grade credit rating.
• Lumen Technologies ( LUMN ) also ran up an elevated leverage level even as it tried to simultaneously balance aggressive capital expenditure spending in a failed attempt to resume top-line growth, significant buybacks, and a huge dividend payout of $1 per share.
• AT&T ( T ) had to cut its dividend after a lengthy dividend growth track record because of its numerous failed acquisitions and poorly performing core telecom business which had left its balance sheet weighed down with a substantial debt burden.
• Medical Properties Trust ( MPW ) leveraged up its balance sheet in pursuit of its aggressive growth program in which it acquired for-profit hospitals hand-over-fist. However, it began to deal with tenant financial weakness and short attacks in the wake of headwinds from COVID-19. While it tried to fight off shorts for as long as it could and even continued to hike its dividend, rising interest rates combined with continued weakness in its underlying tenants forced management's hand in slashing its dividend. We think another dividend cut could even be on the way here as it appears that MPW's largest tenant's troubles may be only beginning .

Given these numerous tragic examples, it cannot be overstated just how important it is for dividend investors to focus on companies with prudent balance sheet management, characterized by low to moderate leverage and a low chance of facing financial distress. The good news is that earning high income yields and investing in companies with strong balance sheets are not mutually exclusive, as there are dozens of companies in the market today that offer very attractive dividend yields while also having robust balance sheets. Three examples of this include Enterprise Products Partners ( EPD ) (a 7.5% yield and an A- credit rating), Realty Income ( O ) (a 5.2% yield and an A- credit rating), and Brookfield Infrastructure ( BIP , BIPC ) (a 5.3% yield and a BBB+ credit rating).

Investor Takeaway

The history of balance sheet-induced dividend cuts is clear: dividend investors should heed Warren Buffett's warning about the risks of overusing leverage. While the yields and total return potential are often extremely attractive, smart investors should steer clear, because even the most skilled and successful investor can see years of hard work and successful investments wiped out in a short period of time due to overleveraging his investments. Instead, investors should content themselves with slow and steady compounding and allow time to work its magic. For the investors who - like Buffett - can say no to leverage and employ the time-tested principles of value investing and allow the math of dividend compounding to work for them, the long-term rewards are substantial and quite attainable.

For further details see: