Understanding financial markets requires at least some understanding of leverage, the act of making trades that multiply potential returns for your assets. Leverage typically involves borrowing money to maximize returns, but certain financial instruments, like options or futures contracts, can also be used to create the same result.
Leveraging is rarely a viable strategy for the individual investor, whose appetite for risk in investing their retirement nest egg or kids’ college fund is, understandably, pretty low. However, for companies that regularly deal with various forms of risk, and can secure rates for loans no individual could ever dream of, leverage is an essential tool for maximizing returns.
So while you may never plan on making plays using borrowed money (or at least you shouldn’t be), any number of companies you might want to invest in already are. And, as such, it’s probably worth understanding how leveraging works.
So let’s say you’re a betting man (or woman) and feel pretty certain that the Acme Company is going to announce that it has, at long last, produced a foolproof trap for catching road runners. As such, you’ve got a strong hunch that shares in Acme are poised to skyrocket some 200 percent, given the high demand for such a device in the all-important coyote market.
Unfortunately, you’ve only got $1,000 to your name at the moment. You’ll only be able to make a $2,000 profit on your trade even if you go all in on Acme stock. It’s a nice gain, but considering that you correctly anticipated a stock tripling in price, you might have hoped for more.
But what if you had a line of credit with your bank for up to $9,000? You can borrow that $9,000, purchase $10,000 worth of Acme shares on Friday, sell those share for $30,000 after Monday’s pop, pay the bank back its loan with minimal interest costs, and end up pocketing about $20,000 in profit.
By borrowing $9,000, you would have leveraged your assets at a factor of 10:1. For every $1 you chipped in, you had $10 working for you. And your potential returns jumped ten-fold as a result.
Obviously, there’s almost never real-world examples like those. Any investment carries with it a certain amount of risk, risk that’s amplified by leverage. Sure, borrowing $9,000 to buy a stock looks like a genius move on Monday if the stock pops 200 percent (or really, even if it increases at all).
However, if Monday morning’s televised demonstration of the new road runner trap ends with the poor test coyote getting crushed under a 10-ton boulder and sheepish Acme executives admitting yet another failure, you’re not looking at all like a genius. If the stock declines more than 10 percent (which wouldn’t be surprising, the boulder LITERALLY flattened that poor coyote), you’re out your $1,000 and in the hole to the bank for whatever portion of the loan your assets no longer cover.
You multiply your returns by leveraging your assets, but you can also multiply your losses as well. Leverage is only a sensible strategy when you have a degree of relative certainty about your investment. In practice, that certainty usually means the returns are limited. The market tends to be quick in identifying a sure thing, resulting in a near certainty returning nearly nothing in the vast majority of cases.
But, for the massive investment banks involved in asset management, understanding risk is the name of the game. And, with billions in assets acting as collateral for securing attractive loan rates, those banks and/or hedge funds can use leverage in a very calculated way.
They start by focusing on asset classes with minimal risk, like investment-grade bonds.
Then, to maximize their returns on these (virtually) sure things, they borrow enough to heavily leverage each play they make. A half-percent return seems like peanuts, but a half percent return on $10 billion is $50 million, a sum most any bank would love to add to the positive side of its balance sheet.
In essence, banks find bets they can be extremely certain will work out, and then they double down. Except it’s not double down, it’s more like 30-times down. If an investment bank can take out a 1-year loan from one institution at an interest rate of 1 percent, and if 1-year treasury bonds for a sufficiently-stable country are yielding 2 percent, they will borrow as much money at 1 percent as they possibly can to sink into those 2 percent bonds. It’s a hard-fought 1 percent net return, but one made without assuming nearly as much risk as exists for even the safest of stocks.
The caveat here is that even the best financial managers can sometimes blunder in their risk calculations, as the recent housing crisis so succinctly demonstrated. At that point, being leveraged 30:1 seemed like utter and complete insanity. But it’s worth noting that the mistake was in understanding how risky certain assets were (a mistake that rating agencies played a major role in), not in the banks’ basic calculations of how to play the bond markets.
The importance of understanding leverage extends beyond just the financial sector, though.
Any investment, whether in stocks or corporate bonds, should involve a look at that company’s balance sheets. In so doing, a traditionalist might assume that debt is a bad thing, and that companies without any are the most desirable. But a more nuanced understanding of leverage, and how debt can help a company succeed, paints a much more accurate picture.
Systems for stock analysis like the DuPont system, actually tend to favor leverage that’s in line with the average for their industry and size. The ability to borrow money is a sign of financial health, and using every available asset to promote growth and improve shareholder returns is something you want to see from a prospective investment.
Say you’re still holding Acme stocks after the 15 percent drop on Monday prompted by the debacle with the 10-ton boulder. At that point, if Acme can secure a cheap loan to buy up a smaller company with a working road runner trap, you would probably want them to do so, even though it involved the company taking on more debt.
In that case, the debt would just be a strategic use of available assets to improve the company’s earning potential. And failing to take advantage of the buying opportunity just to avoid debt could be a short-sighted mistake that hurts the company’s long-term health.
Again, leverage isn’t just risk for risk’s sake. At least it shouldn’t be. Ideally, it’s calculated risk deployed at the right time in order to maximize returns. Knowing how and when to deploy leverage is an important to the healthy operation of any company, and any company using their ability to borrow strategically and intelligently is probably a smart company to invest in.
While any individual investor borrowing money to make investments is probably making a huge (HUGE) mistake, understanding how leverage works can help you identify in which companies make good candidates for your portfolio.
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Article initially appeared on equities.com
Credit: equities.com, WSJ, NYSE
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