As I’ve previously pointed out, leverage is a major source of risk in an investment portfolio. Not only does borrowed money magnify gains and losses, it also introduces obligations and requirements. Without leverage, a company with failing financial health has options available. It can reduce, then stop dividends, it can sell assets and it can take on new loans. A company that is highly leveraged has none of these options, and a failure will arrive much more quickly and with less warning to owners. Let’s look at how leverage puts a portfolio at risk of failure.
First, leverage can be used to purchase investments. Because equity investments are considered assets, it is quite easy to buy them with borrowed money. An investor could borrow against their own credit, or against other assets to arrange a line of credit. An investor could borrow against the investments themselves, either with a margin account, usually in the case of stocks, or with a 1:1 investment loan, usually in the case of a mutual fund. The loan will magnify gains and losses as a percentage of the original investment. Suppose $50,000 is invested but, using a $50,000 loan, $100,000 of stock is purchased. If the stock portfolio rises to $110,000, that’s a 10% increase on the total investment, but a 20% increase on the investor’s capital. Now let’s assume that this return is earned over the course of a year, and the loan is at an interest rate of 5%. The net return, after paying interest, is $10,000 – ($50,000 x 5%) = $7,500 / $50,000 = 15%. In this example, the investor earns 15% on his original investment. But what if the market falls by 10%? A loss of $10,000 and an interest cost of $2,500 mean -$12,500 / $50,000 = -25%.
From the two hypothetical examples above, we see that the return profile has been fundamentally altered. The lender is paid a 5% guaranteed return per year, no matter the performance of the equity investment. The investor, however, loses more from a negative return than they gain with a positive return. Because probabilities are unknown, and unknowable, with stock market returns, the profile of the returns is important. Most investors will prefer a return profile with more possibility to gain than to lose. This is the basic tenet of value investing: buy something that’s already low so that there’s more to gain than to lose.
Second, leverage can be embedded within investments that are held within a portfolio. Businesses borrow money to fund their operations. The result is that the return profile for the business is altered. A corporation that has no debt outstanding and no bonds or preferred shares, has full control of how to use their revenues from operations. They can choose to pay bonuses, pay out dividends, invest in productive assets or expand their operations. On the other hand, a corporation that has a significant amount of debt has less flexibility in the use of their revenues. They must pay their short-term liabilities, pay interest and probably principal on long term liabilities and bonds outstanding; if not, they will be forced into bankruptcy. Only then do they have the option of paying bonuses or dividends on preferred shares. Last, they can choose whether or not to pay dividends to common shareholders. Similar to the example of the leveraged investment portfolio above, the return profile favours the lenders, at the potential expense of the owners.
Third, leverage can easily be magnified. This skews potential returns even further to the negative side. Shares of a company that has a 200% debt-to-equity ratio can be purchased by an investor in a margin account using money borrowed from a bank. At the extreme, the money can come from an unsecured line of credit (eg. $10,000), deposited to a margin account and used to buy shares that qualify for 2:1 margin, for a $30,000 investment. That equity, in the company, is accompanied by 200% long-term debt, for an enterprise value of $90,000. The investor has, in effect, used no capital of his own to control $90,000 of enterprise value.
In this example, let’s also review the impact the obligations to the various lenders. We will assume a 6% rate of interest in each cash, which is probably at the low end of a realistic range. Remember that if an interest payment is missed on any of these loans, the investment will fail and capital will be lost. The line of credit at 6% + the margin account at 6% + the company’s long-term debt at 6% mean that the first 18% of profits are paid to banks. If corporate profits exceed 18%, the investor begins to make a positive return. Although many companies may be able to achieve this, especially during the growth phase of the economic cycle, this is not a low hurdle. The return profile is heavily skewed, and the risk of a loss of capital is substantial.
The effect of borrowing money is to skew the potential returns in favour of lenders at the expense of the owner or equity investor. Magnifying leverage has the effect of magnifying risk. It is very easy to increase the leverage of a portfolio, and it will probably improve returns when the investment environment is positive. But when times are lean, a portfolio with significant leverage, external or embedded, has a much higher chance of failure, causing permanent loss of capital. Using minimal to no leverage greatly improves the robustness of the investment portfolio and improves the chance that a financial plan will be successful.