The Leverage Paradox
What is Leverage ?
Interestingly, “leverage” finds itself in most discussions around bad business and blow ups or bear markets, usually also synonymous with “blow ups” but what exactly is leverage?
Leverage is the use of “borrowed money” to magnify return
to further simplify leverage is when a business would borrow and invest to earn incremental ROCE, however this process is only profitable for as long as such ROCE remains greater than rate at which money was borrowed.
The Evil Reputation of Leverage
Interestingly, Leverage has only been spoken off when things are falling apart. The most recent example being during the Global Financial Crisis of 2007 and the IL&FS Debacle in India.
Lets understand the cycle of leverage and if it is in fact as evil as we have been made to believe.
Leverage makes its way into companies when the cost of money is less than the return on invested capital. The same may happen during an economic expansion or when interest rates are low. Interestingly, each of those can trigger the other, viz- during a low interest rate regime more businesses would move towards expansion since cheaper money is available to finance it, while on the other hand if an economy is broadly in expansion people would get higher return on invested capital and money would appear to be cheap in comparison even if interest rates do not move lower.
While, this continuous process of borrowing cheap and investing for higher returns is in full flow- demand for money would begin to increase the price of money viz- interest rates and heavy investments would begin to reduce the return on investment.
By the time this investment cycle matures most businesses would now have much higher leverage than they intended on and to make it worst with decreasing returns on re-investment.
The effect of Leverage, however doesn’t restrict itself simply to businesses- it trickles down to most people.
These businesses now making higher absolute earnings would increase employment, increase compensations to current employees and management and all that higher liquidity would make its way to the stock markets, the real estate markets- pushing prices up everywhere- making everyone more money than before. The problem making more money- is people land up extrapolating good times to last forever, people go ahead and buy more and expensive things on LEVERAGE. Stock markets see an increasing amount of ‘leveraged trading’, ‘leveraged buy-outs’ and even ‘leveraged investing’ (margin based investing).
While, every one is too busy getting drunk on leverage- which is up-till now proving to be positive. People tend to forget about the forthcoming hangover.
House of Cards
As the interest rates go up, people and businesses are faced with two options to either A- return the borrowed money or B- accept this new and higher rate of interest.
While, returning the money seems like the best option- most people can’t do so due to lack of having money lying around. Which means they either need to pull out money from businesses, expansion plans, stock markets or other investments or refinance loans, viz.- take on incremental leverage (Debt Trap).
However, either of the two cases tends to disrupt the broader economic environment. Disrupted economic environment reduces investment opportunities, reduced capital flow further increases interest rates till a point where borrowers are forced to pay up.
Companies eventually have to abandon expansion ops, the increased employment which was justified with higher earnings and increased operations is now faced with crisis- where the earnings reduce and costs go high, the same companies must now lay off employees- the same employees who saw increased earnings and were only now getting used to higher spending have their loans foreclosed. All of which leads to higher bad debt lower financial liquidity which continues to push the interest rates higher making more people and businesses even more uncomfortable than before.
Before we know it, everything starts to tumble down like a house of cards.
As more people get effected, governments are forced to step in- to increase liquidity, reduce interest rates, buy bad loans etc.
In the process, reinvestment opportunities are again available in abundance due to reduced availability of capital, for all those who kept their capital well-managed. Sooner than later the entire economy is reset for the same vicious cycle of leverage to take place.
Interestingly this cycle has kept up with economy since the inception of leverage and finance
What’s in it for You, as an Investor?
This vicious cycle of leverage has made itself available time after time, but people are usually convinced “this time it’s different”.
People have the tendency to turn a blind eye to underperforming assets. This tendency makes for great business opportunities to the smart investor. When this leverage cycle is in full flow at its peak where everyone is borrowing for higher expansion and higher consumption- bonds are available cheapest while equity keeps moving up. Companies get overvalued, over-optimistic anticipations keep sending equity targets higher increased liquidity fuels the stock prices to reach such targets.
A smart investor would be able to see this over-valuation and be able to sell equity when most people on the street are convinced these prices would trend upwards forever and instead buy bonds which might have become increasingly uninteresting, purely for having “underperformed the market”.
Even worst for the bond investors who sell their bond holdings which have been underperforming to buy the “outperforming equity stocks” and at the top of such cycle. Who are doomed when push comes to shove and stocks come down through the roof, more money rushes to buy the same bonds that are now “outperforming the equity market”. No sooner than later the same equity stocks have seen drastic corrections and now most people on the street are too scared to indulge in this investment they so dearly loved probably a few months ago.
For the same “smart investor” who had bought the boring cheap bonds can now sell them at overvaluation (since the bonds start trading at premiums due to the “flight to safety”) effect and can now buy equity at reasonable valuations if not cheap.
However, I am of the opinion that no one can perfectly time selling out of equity. Considering the same for our “smart investor” being spoken off and assuming he wasn’t able to perfectly time his sale of equity, I’m sure he doesn’t mind the interest payments he receives on his bond investments.