Why investors should exercise restraint on debt

IT IS obvious that all else being equal, people and companies that are indebted are more likely to run into trouble than those that are not. It is the presence of debt that creates the possibility of default, foreclosure and bankruptcy.

Does that mean debt is a bad thing and should be avoided? Absolutely not. Rather, it is a matter of whether the amount of debt is appropriate relative to the size of the overall enterprise and the potential for fluctuations in the enterprise’s profitability and asset value.

The reason for taking on debt, using what investors call “leverage”, is simple: to increase so-called capital efficiency. Debt capital is usually cheap relative to the expected returns that motivate equity investments and thus relative to the imputed cost of equity capital.

Thus, it is “efficient” to use it in lieu of equity. In casinos, I have heard the pit boss say: “The more you bet, the more you win when you win.” Likewise, for a given amount of equity capital, the more debt capital you use, the more assets you can own, and the more assets you own, the greater your profits will be – when things go well.

But few people talk about the downside. The pit boss never says: “And the more you lose when you lose.” Likewise, when your assets decline in value, the more leverage you have employed, the more equity loss you will suffer.

The magnification of gains and losses stemming from leverage is typically symmetrical. A given amount of leverage amplifies gains and losses similarly. But levered portfolios face a downside risk to which there is not a corresponding upside: the risk of ruin.

The most important adage regarding leverage reminds us to “never forget the six-foot-tall person who drowned crossing the stream that was five feet deep on average”. To survive, you have to get through the low points, and the more leverage you carry, everything else being equal, the less likely you are to do so.

Obviously the greatest leverage-related losses occur when the potential for downward fluctuations has been underestimated for a meaningful period of time and thus the use of leverage has become excessive.

Leverage in good and bad times

When things have been going well in markets for a while and debt has been cheap, like it was up until recently, investors view leverage as benign. All they see is that asset prices have been rising, investment returns have been positive, and the use of leverage has paid off in the form of higher returns.

As a result, investors focus only on the favourable aspects of leverage and become interested in employing more of it. Lenders become willing to provide more, and the regulations and mores governing the use of leverage tend to become more permissive.

But when events turn negative, this process goes into reverse. Leverage is penalised, not rewarded. Thus, its use declines. And importantly, lenders provide less and try to demand repayment of outstanding leverage if they can, leading to negative consequences for borrowers. Generally speaking, “normal levels of volatility” – those seen on a regular basis and documented through historical statistics – are used in investors’ calculations and reflected in the amounts of leverage they employ. It is the isolated “tail events” that saddle leveraged investors with the greatest losses.

As with so many aspects of investing, determining the proper amount of leverage has to be a function of optimising, not maximising. Given that leverage magnifies gains when there are gains and that investors only invest when they expect there to be gains, it can be tempting to think the right amount of leverage is “all you can get”.

But if you bear in mind the leverage’s potential to magnify losses and the risk of ruin under extreme negative circumstances, investors should usually use less than the maximum available. Successful investments, perhaps enhanced by the moderate use of leverage, should usually provide a good-enough return, something few people think about in good times.

The right way to think about debt may be best captured by one of the oldest market maxims: “There are old investors, and there are bold investors, but there aren’t many old bold investors.” Using a moderate amount of borrowed capital balances the desire for enhanced gains against the awareness of the potential negative consequences. It is only in this way that one can hope to attain the longevity that most investors seek.