Monday, March 23, 2015

Leverage: The fastest & most likely way to go bankrupt

“If you're smart you don't need it, and if you're dumb, you got no business using it."
- Warren Buffet

Leverage is used by many funds (hedge fund more than mutual funds) as a financial tool to improve returns. Now in the value investing world of equities leverage can be a very dangerous thing. Leverage increases your chances of going bankrupt rapidly. A portfolio management strategy with 1:1 leverage that moves down 50% will be out of the money and the game will be over for the investor. Typically in the value investing world a market move downwards of 50% is a wonderful thing as it provides many opportunities to the intelligent investor. Value investing should then require you to hold a minimum percentage of cash (arbitrarily let’s say 5%) so that in the extreme “six sigma” event you can attend the buying party. For the uninitiated a six sigma event should mathematically occur 0.00034% of the times but in the markets when the going is good the markets find it very unlikely that a 30% fall will happen. And every time it does happen some people start (wrongly) calling it a “six sigma” event. This so called six sigma even seems to happen once or sometimes even more times a decade. So in the value investing communities a “six sigma” event is a buying party!

Implicit leverage via the use of insurance contracts, options and other derivatives is also a dangerous thing unless you really know what you are doing. Even Berkshire uses this mode of insurance floats and short option positions. But getting to a stage where you can value such instruments and can manage that kind of risk is way outside my circle of competence and the scope of this book. Just to note a hedge fund that is short a long term insurance contract is a very dicey thing because a hedge fund does not have permanent capital. Thankfully mutual funds are not allowed do such exotic things and are better regulated on most jurisdictions.

This absolutely does not mean that the businesses you invest in should not be using leverage. But they too need to be using it within limits. Banks will of course use the most, but they should have their capital adequacy ratio in check as per the latest Basel norms. Manufacturing businesses often use leverage but I think anything that is levered more than three times debt to profit after tax should be looked at with a skeptical eye. The business itself could go bankrupt. Anecdotally very rarely do I come across with business with more than one times debt to EBITDA of debt that has good returns on capital. I have looked at over 140 companies in the Indian markets and from the ones I have looked at the average ROCE goes down as the debt/PAT goes up. Yes this is not a random sample but one which contains companies that showed up on some screen or the other but still gives you a sense of why leverage is the fastest way to go bankrupt. This data excludes banks.

Debt/PAT
Number of companies
Average ROCE
Less Than 0
59
56%
Between 0 & 1
40
26%
Between 1 & 2
9
22%
Between 2 & 3
8
24%
Between 3 & 4
5
18%
Between 4 & 5
4
19%
Between 5 & 6
3
13%
Over 6
15
14%