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The Biggest Risk to Warren Buffett's Portfolio

By Sean Williams - Jan 30, 2020 at 6:06AM

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One rising metric may portend trouble for Berkshire Hathaway when the next recession strikes.

Few things have stood the test of time as well as Warren Buffett's investing prowess. Beginning with around $10,000 in seed capital in the mid-1950s, Berkshire Hathaway (BRK.A 0.97%) (BRK.B 0.71%) CEO Warren Buffett has seen his net worth climb to nearly $90 billion as of this past weekend. Had he not donated tens of billions of dollars over the years, there's a very real chance he'd have surpassed Amazon CEO Jeff Bezos as the richest man in the world.

In addition to creating wealth for himself, Buffett has also done a bang-up job for his shareholders. More than $400 billion in value has been created for Berkshire shareholders, even though Buffett's company doesn't pay a dividend.

Buffett's simplistic buy-and-hold ethos, coupled with his focus on just a few sectors of the market, is what's allowed him to be so wildly successful over the years.

However, there are always risks when it comes to investing, and in Buffett's portfolio, his biggest risk might just be the rising use of leverage for his holdings.

Berkshire Hathaway CEO Warren Buffett at his company's annual shareholder meeting.

Berkshire Hathaway CEO Warren Buffett at his company's annual shareholder meeting. Image source: The Motley Fool.

Corporate debt levels are rising quickly

For a long time now, the Federal Reserve has been ultra-accommodative on lending rates. Between Dec. 2008 and Dec. 2015, the federal funds target rate was kept at an all-time low, with nine quarter-point (i.e., 25 basis point) increases to the fed funds rate being passed along between Dec. 2015 and Dec. 2018. Last year, we witnessed three quarter-point rate cuts. Although the current fed funds rate is higher than where we sat a decade ago, it's still well below its historic norms -- and that's important.

Maintaining a low lending rate is the central bank's not-so-subtle hint to businesses that now is the time to borrow money at historically cheap rates in order to expand, hire additional workers, and innovate. And borrow they have.

According to a report from audit, consultancy, and advisory firm Deloitte, released last April, there's been a significant increase in corporate debt security issuances, such as bonds, relative to traditional bank loans in recent years. Between Q1 2011 and Q3 2018, nonfinancial corporate debt grew by 6.3% per quarter year over year, which compares to 4.5% growth for traditional loans.

Furthermore, Forbes noted in a July 2019 report that U.S. nonfinancial corporate debt had nearly hit $10 trillion, representing 48% of U.S. GDP. That's up from the previous peak of $6.6 billion in nonfinancial corporate debt, which represented 44% of U.S. GDP, prior to the Great Recession.

A weighted ball with the word "debt" etched on it, attached by a chain to a bear trap

Image source: Getty Images.

A number of Buffett stocks have significantly increased their debt in recent years

There's no doubt that historically low lending rates are spurring corporate borrowing. But at the same time, there's also the very real possibility that they're increasing corporate leverage, which is bad news if and when the longest economic expansion on record comes to an end. And as economics teaches us, recessions are a natural part of the economic cycle.

There are a number of companies in which Buffett currently owns stakes that have seen a notable uptick in total debt over the past decade. This debt has proved instrumental to their expansion last decade, but it could become their downfall in the 2020s.

For example, American Airlines Group (AAL 0.20%) has seen its total debt skyrocket to $34.4 billion. The merger of American Airlines with US Airways was designed to produce cost synergies and allow the combined company to be more cost-competitive with bare-bones regional airlines. But American Airlines' desire to modernize its fleet well ahead of the need to retire some of its existing planes has ballooned its debt. The airline industry has a very poor track record during recessions, and American Airlines' $29 billion in net debt is the highest in the industry (among the majors). Buffett's Berkshire Hathaway currently holds a 10% stake in American Airlines Group.

Another prime offender is one of Buffett's longest-tenured holdings, Coca-Cola (KO 1.02%). While it's not uncommon for brand-name food and beverage companies to lean on debt to make acquisitions and occasionally fund innovation, it's surprising to see that Coca-Cola's debt has tripled over the past decade to almost $44 billion. While Coca-Cola's profitability certainly isn't in question, its debt-to-EBITDA of nearly four is a bit worrisome, especially in a relatively slow-growth, mature business model. While this leverage could certainly help the company do more with a relatively low growth rate, it's more of a risk than reward at this point.

A neat stack of one hundred dollar bills wrapped in chains and locked

Image source: Getty Images.

The same can be said for Kraft Heinz (KHC -0.03%), which saw its debt balloon after Heinz acquired Kraft Foods (and grossly overpaid for the deal). Today, Kraft Heinz has $31.3 billion in total debt, even more in goodwill, and very little financial flexibility at a time when it needs to reignite growth in its core brands. Worst of all, with 325.6 million shares owned, Buffett is pretty much stuck in Kraft Heinz and can only hope the company rights the ship. With 26.7% ownership in Kraft Heinz, attempting to sell would only further crush the company's already depressed share price.

With an all-time record $128.2 billion in cash on hand, it's not exactly as if Buffett is ill-prepared for the next recession. But given just how much debt a number of his holdings have piled on over the past decade, the next recession could hit Berkshire Hathaway a lot harder than previous pullbacks in the stock market. It's something to take into consideration if you own Berkshire Hathaway stock or have considered mirroring Buffett's investments.

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Stocks Mentioned

The Coca-Cola Company Stock Quote
The Coca-Cola Company
$63.55 (1.02%) $0.64
Berkshire Hathaway Inc. Stock Quote
Berkshire Hathaway Inc.
$412,900.00 (0.97%) $3,950.00
Berkshire Hathaway Inc. Stock Quote
Berkshire Hathaway Inc.
$274.97 (0.71%) $1.95
American Airlines Group Inc. Stock Quote
American Airlines Group Inc.
$12.71 (0.20%) $0.03
Kraft Heinz Intermediate Corporation II Stock Quote
Kraft Heinz Intermediate Corporation II
$38.13 (-0.03%) $0.01

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