“Steal a man’s wallet and he will be poor for a day. Teach a man to leverage trade and he will be poor his entire lifetime”
The below was originally written as a memo to our shareholders. However, we realised that leverage is a dangerous tool that is often used incorrectly, especially in a frontier market like Sri Lanka. Hence we decided to publish our views on it to help educate the market. As always, none of the below is advice in any way, shape or form. It is just our framework for dealing with a complex problem.
The Leverage Cycle
The debt/leverage cycle is one of the most important cycles in markets to be aware of. It adds fuel to the fire of the overall market cycle, amplifying the bull run but also often being the cause of the eventual capitulation and market crash, at which point a liquidation cascade amplifies the downward movement of the market as well. The cycle can be expressed as below:
As markets start to go up, investors become increasingly optimistic. They feel that their exposure to the market is not enough, (regardless of how much they have put in), and seek to amplify their profits by borrowing funds (usually providing their equity investments as collateral) and putting those borrowed funds into the market as well.
These additional funds further propel the market, making leveraged investing a winning strategy. Others see this and also pile on (“if it worked for him why wouldn’t it work for me?”) while at the same time existing investors borrowing more. (“If it worked last month why won’t it work today”).
Hence we enter a reflexive loop, with borrowed funds increasing market values thereby attracting more funds. This often leads to a period of strong price appreciation and market mania with shares swinging from being undervalued to becoming overvalued.
Eventually this virtuous cycle slows. It could be due to an external shock, increased interest rates, or banks cutting back exposure to the sector.
As the cycle slows, sellers' profit taking overwhelms the slower stream of buyers, leading to prices going down.
As prices go down, leveraged borrowers face margin calls (Their lenders require them to put in additional funds to reduce the debt they have taken as their share collateral is worth less now). Most lack the funds to meet these margin calls and are hence forced to sell.
We now enter a reflexive loop going the other way. Forced selling leads to falling prices, leading to more margin calls and hence more forced selling. This is amplified by the market panicking as share prices fall, further boosting sales even of those less leveraged. This leads to a collapse in share prices.
This loop eventually ends when all the excess debt has been cleared out, or some external positive catalysts allow prices to start rising again.
We then return to 1.
The above cycle is as old as human civilisation. No matter what we say or do, it is part of human nature to be greedy when things are going well and take things too far.
If you are wondering if you should use leverage when investing, the answer is probably a no. However, we are aware of human nature, and think simply telling people not to leverage trade will not actually work. It is to better educate readers about the pros and cons of leverage, as well as the best policies to mitigate the risks. We believe that a well thought out leverage policy, managed with discipline can be a net positive in the hands of a professional investor.
The Risks of Leverage
Before exploring the benefits, it is more important to ensure the reader is familiar with the significant risks that come with debt.
The Biggest Risk: Being a Forced Seller
As Howard Marks said, the cardinal sin of investing is being a forced buyer or a forced seller. It is critical to never be in a position to make forced investment decisions. In our view, the risk of forced selling is the most significant and damaging risk that needs to be avoided at all costs. Forced selling happens if an investor ends up with too much debt in a position whose market price crashes. This triggers margin calls, which, if they cannot be met, lead to a forced sell of the investment at a loss to the investor. Margin calls and forced selling is what takes an investor out of the market. Ensuring one has the holding power to weather the volatility is absolutely critical. Investors should be especially careful about leverage around binary events that cannot be easily predicted (such as elections), as these can lead to sharp swings in the market which can wipe out a leveraged portfolio.
Leveraged investing is path dependent (i,e: It isn't just the starting and ending prices of an investment that matter, but the path taken from start to finish). Even if a share doubles in value, if it first drops and takes out a leveraged investor, he will not benefit from the price doubling. Increasing leverage amplifies this path dependency. This is why having robustness to survive volatility, even if one is confident of the end state is so important.
Erosion Over Time.
The market can remain irrational longer than you can remain solvent. We find that it is much easier to identify undervalued stocks, than predict when an undervalued stock will rise to its fair value. It is very possible that a cheap stock with significant upside remains cheap for a very long time. This is not a major issue for an investor investing long term unleveraged funds. However, if investing with borrowed funds, there is suddenly the requirement to fund interest as well as meet margin calls on any near term moves. Both of these could force an investor to lose out on a leveraged position that would have otherwise been profitable over the long term, if unleveraged.
Risk of Amplified Losses
In the same way that investing on leverage drives higher returns if you have selected good investments, an investors losses are also equally amplified. Hence it is important to be strategic in using leverage, only doing so when you are confident the odds are in your favour. The below table illustrates how losses explode in a leveraged portfolio
Unleveraged Loss | -50% | -40% | -30% | -20% | -10% |
25% Leveraged Loss | -67% | -53% | -40% | -27% | -13% |
50% Leveraged Loss | -100% | -80% | -60% | -40% | -20% |
75% Leveraged Loss | -100% | -100% | -100% | -67% | -33% |
90% Leveraged Loss | -100% | -100% | -100% | -100% | -100% |
So Why Have We Chosen to Use Leverage
Despite the above negatives, we have made a careful decision to use small amounts of leverage in our portfolio. This is due to the following reasons:
Above All - Leverage Provides Flexibility
We have identified two key competitive advantages that we seek to make use of as investors. The first is having patient, long term equity funding, which allows us to take a long term view, invest through near term volatility, and never be a forced buyer or seller due to redemptions or inflows. The second is having the flexibility to move fast and take advantage of market volatility. If an opportunity presents itself, it will not be there for long, and it is critical to identify it and invest quickly. However, equity capital is cumbersome to raise, inconvenient to shareholders and dilutes those who cannot participate in sudden raises. Hence we are currently forced to hold excess cash to ensure operating flexibility. With low interest rates, this cash can be a drag on our overall performance.
Debt lines allow investors to be fully invested, while also retaining the flexibility to draw down in the event a sudden highly attractive opportunity shows itself. This flexibility creates the chance to swing even harder at fat pitches when they show up, and is the primary point of attraction for debt.
Attractive Funding Costs
Currently interest rates have dropped sharply from an eye watering 30%, with further reductions possible. It is now possible to finance an equity portfolio at around 11%. After adjusting for the 6% net dividend yield of our portfolio, the net cost of funding an equity portfolio would be around 5%. As long as the portfolio can generate capital gains above 5%, borrowing should be financially accretive. 5% is quite a low hurdle rate. It is worth pointing out again, that potential return alone is not a sufficient yardstick for the decision to take on leverage. A portfolio also needs to be robust enough to handle volatility without the investor being taken out by margin calls. Hence risk must also be considered, not just returns.
Amplified Returns
By simple math it is clear that a strongly performing portfolio will generate an even higher return to an investor if it is leveraged, as shown below:
Unleveraged Gain | 10% | 20% | 30% | 40% | 50% |
25% Leveraged Gain | 13% | 27% | 40% | 53% | 67% |
50% Leveraged Gain | 20% | 40% | 60% | 80% | 100% |
75% Leveraged Gain | 33% | 67% | 100% | 133% | 167% |
90% Leveraged Gain | 100% | 200% | 300% | 400% | 500% |
While this is the primary reason most investors choose to use debt, it is worth pointing out that equity returns are already pretty good and leverage purely for amplified returns is really not necessary.
How We Mitigate the Above Risks
While the above risks are serious, it is possible to use leverage in ways that mitigate the negatives and amplify the positives.
Keeping Leverage Low
This is the obvious one. The relationship between leverage and risk is non linear. A portfolio leveraged to 90% LTV is much more than twice as risky as a portfolio leveraged to 45% LTV. Hence keeping leverage low is a simple way to reduce your risk. Our standard leverage target is 0%. We only take on leverage when we are exceptionally optimistic, and even then cap it at significantly below our total debt capacity to ensure headroom. We will never be leveraged to the maximum we can be, regardless of how optimistic and "sure" we are of the future.
Strict Written Leverage Rules With Fixed Targets and Independent Oversight
It is highly tempting to keep buying dips during periods of market weakness when you have extra margin headroom. However, while this makes sense with cash, it can lead to overextension when done via debt. The dip can keep dipping, and can take out leveraged investors. The psychological weaknesses found in any person mean that formal rules should be in place BEFORE building a debt funded investment portfolio to prevent blowing up. Hence we have set strict loan to value ratios well below the margin call levels set by banks and ensure these are monitored by independent parties who are not emotionally invested. This ensures we will not stray from our leverage targets
Maintain a Low Risk Underlying Portfolio
Leverage amplifies risk in a non linear fashion. Hence a leveraged high risk portfolio will have significantly more risk than a leveraged low risk portfolio. The higher the risk and volatility in a portfolio the less leverage should be used. For example, if the portfolio companies show some of the below characteristics, they will lead to a higher risk portfolio and hence should have less portfolio leverage.
High financial borrowings
High cyclicality of revenue
High political risk
High share price volatility (for instance due to a low free float)
Low diversity between portfolio companies
Upcoming binary catalysts (e.g: A Biotech company with a drug approval coming up)
Keep Borrowing at Levels That Can Be Repaid by External Sources
In the unlikely event that there is a huge market crash that triggers margin calls even for a portfolio with low leverage, the next line of defence is to have funding available to pay down debt if absolutely necessary. This is again why it is important to manage your debt levels, and never borrow more than you can afford to repay if push comes to shove.
Ensuring a Strong Positive Relationship With Lenders and Never Being Reliant on Only One
The relationship between a borrower and lender must be treated as an infinite sum game where win-win outcomes are the goal. As a borrower, it is a must to act in good faith, in both good times and bad, to ensure you maintain the confidence of the lending party. At the same time, it is also important to diversify your funding to minimise reliance on any one counterparty, as they may go through their own specific challenges that could lead to your funding being affected through no fault of your own.
Keeping Excess Borrowing Capacity
As we mentioned, the main advantage of leverage lines is they provide flexibility to move fast when an opportunity arises. This is one of the key advantages, and is totally lost if you are operating with fully utilised lines. Hence we never operate with fully drawn financing, and in the event our credit headroom gets too narrow we intend to conduct equity raises or sell assets to reduce the gap.
Application Outside Investing
We believe a lot of these guidelines are simple common sense, and can also be applied to other situations when one borrows funds, such as purchasing a house or funding a business. For example:
Keep your borrowings low. Lean towards the side of caution. If you are uncomfortable with your debt levels, you must focus all attention on paying it down.
Even if you don’t need the funds, it is worth having prearranged overdrafts ready with your banks so you are never desperate for funds in an emergency situation.
You should not be too reliant on any one bank and diversify your funding sources while ensuring goodwill with all your banking partners.
Never borrow more than you can repay on short notice.
Always have a plan on how you would repay your debts (either by having assets earmarked for sale, or sources of funding such as shareholders to tap into)
Ensure the interest rates are not too punitive and erode too much value over time.
When borrowing to fund a project, don't only focus on potential return, but also on the risks.
Your default state should be unleveraged and you should only take on debt for opportunities where you have a very high confidence in a good payout.
Proceed With Caution
We want to emphasise again, our main message is that the reader should not use leverage unless they are absolutely sure they know what they are doing and understand the risks. In the event the reader does choose to proceed, we hope they find the above useful.
Nice article. Looking forward to the next memo.
This article reminds me of this - https://x.com/morganhousel/status/1376534015457460229