Berkshire Hathaway’s (BRK.A, BRK.B) Warren Buffett once famously said, “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.

The Perils of Leverage in Investments

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, it can be particularly tempting to further amplify those gains with borrowed funds, especially when stock prices rise day after day. However, this entails significant risk, as stocks can drop just as quickly as they rise, and leveraging can lead to catastrophic failure.

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.

As Warren Buffett points out, the use of leverage is fraught with danger, especially when used in large quantities. It can lead to catastrophic failure and potentially even bankruptcy. The risks with leverage are amplified alongside the potential gains. Thus, when markets crash and/or business expectations fail, leverage can potentially multiply your principal by zero, effectively wiping out all of your accumulated money.

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. Leverage 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.

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, leverage 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), Algonquin Power & Utilities (AQN), and Lumen Technologies (LUMN).

• Energy Transfer 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 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 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.