No doubt about it, borrowing money to enhance the profits of a business or an individual account has tremendous appeal. When everything is going correctly, the notion that one is imperiling himself or his business by employing leverage seems ludicrous. Leverage carries a similar appeal to the sweet voices of the mythical Sirens who attempted to lure Greek sailors to their death. Unfortunately, unlike Odysseus who ordered his sailors to tie him to the mast to prevent his destruction, investors rarely take such precautionary measures. Rather, they succumb to the appeal of added profits without regard to the potential danger which lies ahead.
Leverage, Hedge Funds and Counterparty Risk
I used to have a good friend who was a local bookmaker. He was not among the world's smartest men but he was extremely savvy. He recognized not only the dangers of excessive leverage but also the concept of counterparty risk. He never let a person bet until they had settled up, and maintained low wagering limits and never laid off any wager. A lay off refers to the practice of calling off a bet to another bookmaker in an attempt to reduce potential losses. You see, if you lay off, you expose yourself to counterparty risk whether the bet wins or loses.
Excessive limits and failure to settle accounts amounts to the equivalent of leverage since all my friends' wagers were taken on credit. Excessive credit would have overexposed him to a disaster in the event that an inordinate amount of players experienced winning seasons. The losses would have been exacerbated if one of the counterparties was unable to pay him. It seems he was a good deal wiser than hedge funds which bought credit default swaps as protection against highly leveraged positions in fixed income and structured investments. Not only were these investments highly leveraged, so were the firms which sold the credit protection.
Leverage is commonly used by hedge funds to supercharge gains in an attempt to exploit tiny inconsistencies in fixed income and derivative markets. Leveraged investments strategies such as bond arbitrage work out well so long as the market behaves efficiently and the losing side is able to pay. Risk-free leveraged hedges, however, only exist in theory. I am not implying the sole reason for the near global meltdown in 2008/2009 was excessive leverage; however, it provided the rocket fuel that ignited the fire.
Leverage and Individual Investors
Excessive leverage puts investors in peril if the market turns quickly against them. As I have discussed in prior articles, many individuals who fancy themselves as investors are little more than momentum-based speculators. Many of these "investors" employ margin in their trading accounts in an attempt to increase profits. If the market turns quickly and decisively against their positions, margin calls can quickly wipe out their account balances.
Time is the investor's best friend so long as he has purchased an equity well below its intrinsic value. A patient investor can wait out the market through periods of excessive pessimism and unjustified drops in his equity prices, so long as he has not employed excessive margin. John Maynard Keynes stated it perfectly: "The market can stay irrational longer than you can stay solvent."
Return on Equity vs. Return on Capital
Many investors fail to realize the important distinction between Return on Equity (ROE) and Return on Capital (ROC). ROC is a much more conservative and useful valuation tool than Return on Equity because it takes the debt of the company into account. For my purposes, I am going to define ROC as ROE plus debt. Again I turn to Warren Buffett for an explanation:
"To evaluate [economic performance], we must know how much total capital — debt and equity — was needed to produce these earnings."
Simply stated, unleveraged returns should never be compared to leveraged returns. That is precisely the error that investors commonly make when they evaluate businesses. If they discount the risk of debt, they invariably select the leveraged company which boasts a superior ROE. It amounts to comparing apples and oranges. Leverage can amplify earnings, but it also introduces a much greater element of risk.
Allow me to present a hypothetical example that illustrates the point: Two brothers, Bert and Larry, each inherit $100 thousand and decide to go into business. Larry, who has acquired the nickname "Larry Lard" due to his rotund figure and lack of mobility, spends a considerable amount of time at the local tavern, imbibing. Bert on the other hand is very interested in developing the perfect cassoulet recipe. For those of you who do not speak French or watch cooking shows, that is a fancy name for a bean casserole.
Larry has noticed that the local bar owner recently purchased a new SUV and decides to open an off-sale liquor store. He names it Larry Lard's Libations. Bert on the other hand decides to open a restaurant. He names it Bert's Beanery.
In his first year Larry nets $20 thousand and a smug Bert nets $30 thousand, utilizing his secret cassoulet recipe. Clearly Bert's business must be superior, since he nets 50% more than Larry on an annual basis, right? Not so fast. First we need to study the returns a little closer. It turns out that Bert leveraged his house and borrowed an extra $100 thousand to finance his Beanery. Larry did not borrow a dime, using only his inheritance to finance his liquor store. Bert's business required 200 thousand in debt and equity to earn $30 thousand, a return of 15% on capital. Larry Lard's business returned 20% on the $100 thousand of equity requiring no debt. Larry clearly has the better business; furthermore, it carries much less risk.
If we merely calculate ROE, however, Larry's business shows a 20% return while Bert's shows a 30% — a most deceiving result. ROC paints a much clearer picture of a business when debt is part of the balance sheet.
Enterprise Value vs. Market Capitalization
Market capitalization represents the share count of a company multiplied by its price per share. Enterprise value (EV) equals market capitalization plus debt minus cash. Ratios that depict earnings multiples such as price-to-earnings or price-to-free cash flow should always be figured in terms of enterprise value instead of market capitalization, since EV factors in the value of excess cash and debt.
If the management of Company A attempts to take over Company B, the significance of EV becomes obvious. If Company B is debt-laden, Company A must figure in the assimilation of debt into their offer price. The offer must reflect the value of the business less the assumption of debt.
Conversely, if Company B holds excess cash, the offer price per share needs to reflect the cash on the balance sheet plus the value of the business. Unfortunately, most investors still evaluate earnings power in relation to market cap instead of EV.
Recessions and Excessive Leverage
Economic slowdowns add additional stress to debt-laden companies. Recessions dampen the earnings power of most companies; however, heavily leveraged companies face the risk of credit downgrades and failure to meet debt covenants. When such events take place the probability of capital loss on an investment magnifies significantly. Let me use Gray Television (GTN), one of my poorest investments ever, as an example.
Gray Television operates a number of local television stations, typically in smaller cities with universities. Every two years they reap the benefits of heavily political advertising revenues providing an ongoing earnings stream for the foreseeable future. GTN had a long history of healthy free cash flow, particularly on the even-numbered years which were beefed up by extensive political advertising revenues. In their case it appeared that politics was the gift that would keep on giving. I was of the opinion that the market was overreacting to declines in their base advertising revenue and not appreciating the ongoing moat which existed in their biannual political bonanza. I waded in fearlessly; I failed to recognize the precarious situation which in which the company would be placed, should the United States fall into recession. That situation was a direct result of the enormous debt they carried on their balance sheet.
When they signed their new debt agreement which considerably reduced their interest expense, I became all the more confident. The covenants of the agreement appeared easy to meet, and I underestimated the potential risk of the enormous leverage. Unfortunately, the low earnings of an off election year coupled with the 2008 financial meltdown which severely damaged nonpolitical revenues, placed them in danger of failing to meet their debt covenants.
Along with most stocks the companies stock price plunged; in fact, it fell well below a dollar. The threat of bankruptcy became a realistic possibility. The company ultimately survived by raising capital by issuing high interest-bearing class c preferred shares. The interest on those shares rose steadily if the principal was not paid back quickly. The shares had the effect of raising the yearly interest expense precipitously and I decided that my shares were now more useful as a tax loss carried forward instead of a long term investment. I took the tanning of my life but emerged a much better educated man.
Finally, I will make some suggestions that investors should follow if they decide to invest in heavily leveraged companies. As far as leveraging one's own account, I find that to be unacceptable to the average investor.
1) Demand a greater margin of safety when investing in highly leveraged stocks. Such stocks require lower price to tangible book ratios, and greater historical earnings yields to justify the added risk.
2) Don't put as high a percentage of your portfolio in highly leveraged companies. Since the risk of capital loss is greater, one should take smaller positions.
3) Demand a much higher potential upside when buying highly leveraged companies. It makes no sense to look at such stocks unless the investor perceives that the intrinsic value of the company could result in a multi-bagger. Higher risk only makes sense in relation to higher potential rewards.
4) Bear in mind that purchasing highly leveraged companies during times of economic slowdowns is extremely risky. Be certain that the company can survive an extended downturn without being forced to severely dilute the value of the shares or worse yet, be forced into bankruptcy.
This concludes my series of articles on the Tenets of Value Investing. I welcome all comments and criticisms.