The Use of Leverage

Leverage in and of itself isn’t bad, but it must be carefully considered.  It can become a problem either because investors never take the time to properly consider it or because investors over use leverage in an attempt to increase their returns.  The over use of leverage is the ultimate financial temptation. It is especially tempting when times are good and the economic outlook is nothing but optimistic. It is also tempting to over use leverage when everyone else is doing it and you begin to feel you are being left behind.  But leverage can be dangerous, especially at extreme levels.  There is hardly a single example of a major financial implosion that didn’t involve the over use of leverage.

Leverage can also distort investment decision making by masking the true merits of the underlying investment. By applying leverage, investors can become distracted and fail to properly scrutinize the true merits of the underlying asset. Buying with borrowed money doesn’t make anything a better investment or increase the probability of gains, it merely magnifies whatever gains or losses may materialize. Finding great underlying investments is hard. It is much easier to compensate for that fact by simply applying more leverage to mediocre or below mediocre investments to still get your return.  Leverage is a great distorter. It masks who is a good investor and who can simply sign up for debt.

Therefore, to oversimplify the above paragraphs, the overuse of leverage has two main general causes:

1. Greed – People want to make money quickly. They will get lulled into a false sense of security when times are good and other people are using leverage.
2. Incompetence – Leverage can be overcompensation for lack of true investment skill.  Its easy to apply leverage. Anyone can apply leverage therefore people do.

Many times the above two causes are working in tandem.

Leverage Can Have Large Effects

Many people fail to realize how large an effect leverage can have given certain changes in the value of their investment.  Take a common situation that happens every day: a real estate investment is made in which the person puts 20% down and takes out a mortgage for the other 80%.  A loan to value of 80% is quite common in the industry and it wouldn’t be unheard of to use even more leverage.  But for all of the investors that engage in this transaction every day, I bet only a small number have explicitly considered how this amount of leverage will influence the value of their equity given changes in the total value of the property.

For example, lets say after you purchased the real estate investment the total value of the property declined by 10%. What would happen to the value of your equity? If you had bought the property by putting 20% down, a 10% decline in the the value of the property will lead you to suffer an incredible 50% loss in your equity.  10% declines don’t happen all the time, but they happen frequently enough that the scenario should at least be considered.  My guess is very few investors realize they could lose half their money with only a 10% decline in the value of their property.

Good investors should have went into the investment looking for a return from the cash flow producing ability of the property over time.  So any temporary market declines should be able to be met with some level of indifference.  But in reality this level of emotional control is likely rare, especially when large declines are unexpected.  For most people, a 50% decline in the value of their equity won’t cause them to act more rationally.  Their use of leverage will have exposed them to a level of volatility that their emotional temperament is not suited to handle.

Breaking Apart Return on Equity

The return you receive on your equity in an investment is driven by two factors:  1) the return generated by the underlying investment assets and 2) the amount of leverage being applied.  The return on equity equation can be broken down to reflect these two factors.

 Notice that Total Assets in the diagonals cancel out leaving the more general form of the return on equity equation which is

But looking at the simplified ROE equation doesn’t really tell you much because you can’t tell what portion of the return came from productivity of the underlying investment (skill) and how much came from the effects of leverage.  Therefore breaking apart return on equity into its component parts like it was done above is far more useful.

In every investment, some portion of your Return on Equity will be driven by the returns being produced by the underlying investment assets and some portion will be driven by leverage.  If you are using no leverage, your total assets will be equal to your shareholder equity and therefore your equity multiplier will simply be 1.  Your Return on Equity will just be the Return on Assets.  Without the distortion of leverage you can see a pure reflection of the merits of the underlying investment opportunity.  If you have no leverage and your return on assets is 5%, your return on equity will be 5% as well.

On top of these pure unleveraged asset based returns, the effect of leverage gets layered in.  Having debt will move your equity multiplier above 1, amplifying the effects of your original asset based returns.  The more leverage you take on, the larger your equity multiplier. If your original unleveraged asset based returns were 5%, you could increase your return on equity simply by increasing your leverage.  If you have twice as many assets than equity (multiplier of 2), then your return on equity becomes 10%.  Three times as many assets as equity, and your return becomes 15%

Notice why the temptation of leverage is so great. In order to get better returns you don’t have to do anything to improve the merits of the underlying investment. You can keep the returns on the underlying assets constant, even if they are small, and still produce large returns on equity simply by increasing your equity multiplier (leverage).

A Few Examples From the Public Markets

Remember that when considering investment opportunities, return on equity is comprised of 1) an underlying return on assets and 2) a leverage component that multiplies those underlying returns.  For each investment, your returns will be comprised of some mixture of the two.  Here are some examples from major corporations from the trailing twelve months as of Q1 of 2018:

Notice how each of these companies vary in their ability to generate strong returns from their underlying business assets.  Look at Visa which benefits from a large economic moat driven by its network effects, brand loyalty, and its capital light operating model. It generates a 12% return on its business assets before taking any account of leverage.  Compare that to a business like Toyota which is challenged by a competitive, low margin, cyclical, and capital intensive business.  Toyota is able to generate only a fraction of the return on unleveraged assets as Visa is because of huge differences in the attractiveness of the two businesses.

Notice next how much leverage low return on asset businesses must take on to achieve comparable return on equity.  International Paper and AT&T must employ massive amounts of leverage to achieve the same kind of results as more attractive businesses such as Apple and 3M.  If you only looked at the companies’ Return on Equity you wouldn’t know this though.  Only by breaking Return on Equity into its component parts can we see how much return is created by the attractiveness of the underlying business and how much of the return must be compensated for by the use of increasing leverage.

Leverage is fine to use but for the fact that it can mask the attractiveness of the underlying investment assets.  Many people get sucked in to investments not realizing the vast majority of their return is dependent not on the quality of the underlying business but instead on the large use of leverage. That is why I suggest investors should always separately analyze true asset returns and then consider appropriate leverage.

Focus First on Merits of Underlying Asset Returns

Because of the brute force of leverage, and because anyone can use it, it has the effect of distorting people’s decision making.  People become less concerned about the merits of the underling return on assets because this deficiency can simply be made up for by applying leverage to still get a large return on equity.  Leverage can make us lazy. Really good investments are rare.  It is easy to grow inpatient and resort to increasing leverage as a replacement for investment skill. This is the main defect of the Private Equity industry.

It is ironic that they are called Private “Equity” because it is in fact debt that they deal in most often.  In fact most private equity buyers deliberately try to minimize the amount of equity they must contribute.  Using leverage in and of itself  is of course not bad. But when it becomes dangerous is when it becomes compensation for lack of investment skill.  Many private equity organizations are of the mistaken belief that by taking a poor business and applying leverage you now have a great business.  But applying leverage doesn’t alter the underlying returns, it simply amplifies the original results whatever they may be.

This problem is indicative of a generally flawed approach common in the investment industry.  It results from 2 interrelated issues.  The first is many investors start from some predetermined return on equity requirement and then reason backwards putting in plug figures in order to satisfy their requirements.  A private equity group might say they have to get a 30% return on equity and then rather than seeking out better underlying asset returns because high return assets are hard to find, they will simply reason backward from their return on equity requirement and  pump up their leverage until they get the returns they wanted.

The second related issue is the more general one we saw in the previous section when looking at public investments. It is the mistake of seeing Return on Equity as a single figure and never bothering to break it apart to analyze its component parts.  Investors need to realize that Return on Equity begins with pure underlying unleveraged asset returns and the effects of leverage is a distinct separate component.  Instead, the two components get blended together into a single concept of return on equity. This is probably because the people using the most amount of leverage are actually the ones with the lowest returning underlying assets which is an inconvenient fact that is better to ignore.

There are no shortcuts without substantial drawbacks.  You can’t take a poor business and turn it into a great one simply by applying leverage.  The only way to get large returns from low producing assets is to use dangerously high levels of leverage.  Investors should start by attempting to find opportunities with good underlying unleveraged asset returns.  Only then should investors consider using leverage to enhance these already solid underlying returns.

The use of leverage should be done from a place of strength with high quality assets involved. The use of leverage should never be done as a requirement to hit some predetermined return on equity figure.

Factors Allowing Higher Amounts of Prudent Leverage

As just discussed, the proper use of leverage is to optimize the capital structure of the investment. It should not be the heavy hand by which return is achieved.

There are really two broad factors that increase the amount of leverage we can prudently employ. But remember the application of leverage only comes after we have identified high quality high returning underlying assets. Leverage should not be a work around for investment discipline.

The first factor is the cyclicality of the underlying cash flows.  The more dependable they are the more leverage can be applied.  A company that has subscription based or contractual based cash flows can employ greater amounts of leverage.

The second factor is the amount of fixed assets that can either explicitly or implicitly used as collateral against the debt.  A company with a lot of tangible stuff that creditors can come after if there is a default increases the amount of debt you can use.  The irony here is that all other things being equal, increased capital intensity tends to make for a less attractive investment, but if there is any upside to large fixed asset requirements it is that you can loan against them.

Companies that have both contractually based cash flows and a lot of tangible assets to loan against can reasonably employ larger amounts of leveraged than the typical business. For example cable businesses, pipeline companies, and real estate investments all benefit from having dependable contractual based cash flows as well as physical assets to loan against.  You will typically see the highest use of leverage in businesses like these.

Some businesses have one but not the other factor which may allow it to prudently use only some degree of leverage.  A steel company may have many factories to loan against, but because of the cyclical nature of its business it would not be wise to use a lot of leverage.  This doesn’t stop many of them from doing so however.  Other companies are on the opposite end of the spectrum in which they have dependable subscription based cash flows but no tangible assets to loan against.  A company like Netflix comes to mind.

In any case, the amount of leverage to employ should be a capital structure optimization question based on the dependability of cash flows and the amount of tangible assets that can be loaned against.  The amount of leverage to employ should not be a reverse engineering process where you start with a return requirement and then reason backwards to figure out how much leverage to take on.

Investors should start by seeking out high returning unleveraged assets and then address the leverage question separately.  By mistakenly combining the two distinct components into one, investors cloud their thinking and end up with low returning assets and a lot of leverage to compensate for this uncomfortable fact.