Leverage: Natural vs. Unnatural

10 07 2011

Most value investors are against the use of financial leverage as a general rule. Leverage is defined as “The use of credit to increase ones speculative capacity” but it can also take other more modern forms such as derivative instruments.  The essential of leverage is that it gives the investor the ability to make (or lose) more on his investment than he would otherwise be able to. Common wisdom says, leverage can and will bite you at the worst possible time. Many great investors and firms have juiced their returns via leverage only to watch their concerns be wiped out entirely. Buffet is quoted as saying:

I’ve seen more people fail because of liquor and leverage – leverage being borrowed money. You really don’t need leverage in this world much. If you’re smart, you’re going to make a lot of money without borrowing.

Even the dictionary definition refers to leverage as speculative in nature. Clearly, victims of too much leverage created a risk for themselves that couldn’t have existed apart from their use of leverage. Is this risk intrinsic to leverage or is it a result of its misuse? Can one use leverage to increase long term returns without excessively endangering ones capital? I think so.

First, I believe it’s important to distinguish between what I see as two essentially different types of leverage: natural and unnatural. I’ve never seen these concepts used outside of my conversations with a friend so I will define them. Loosely speaking, natural leverage is the leverage a common stock investor is exposed to by the nature of his investment’s capital structure. For instance, an investment in a company with a high debt to equity ratio such as SuperValu Inc. (SVU). The debt exists on the company level.

In contrast, unnatural leverage is leverage that is employed by the investor in an unleveraged business. Borrowing money on margin or purchasing LEAPS are two examples. The leverage exists on the investor level.

I believe that there is a world of difference between the two types. While there are obviously exemptions to the rule, unnatural leverage tends to be much more potent than natural leverage. In terms of risk, the difference between buying options, where risk of total capital loss is very real, and owning a company with a leveraged balance sheet is immense. I believe that the most important difference between natural and unnatural leverage is the incentive distribution. Management of a company with a poor balance sheet has an immense incentive to reduce the debt. They are incentivized (above and beyond the norm) to act in the best interests of the shareholders. No such incentive exists for unnatural leverage. In my opinion, this is not a trivial point. The power of incentives cannot be over exaggerated (introspection will solidify this point). For what it’s worth, Charlie Munger agrees too.

This isn’t to say that all natural leverage is inherently good. A crappy balance sheet is still a crappy balance sheet. In fact, it’s probably evidence of crappy management. The cases to look out for are the ones where the current management didn’t create the balance sheet issues. Management changes are an obvious instance of this. Special situation are another. Spinoffs, for example, are often times loaded down with debt to relieve the parent company. The spinoff is structured in such a way as to satisfy the purpose of the spinoff- not to create the optimal capital structure for success. Once it’s an independent company, the odds are better that management will be interested in making the best of the situation and reducing debt if necessary.

So what about Buffett’s statement that you don’t need leverage to be successful? The premise behind his statement is that leverage is dangerous by its very nature. I don’t agree and I don’t think that using leverage means you need to leverage up 10 to 1 or even .5 to 1. If using small amounts of leverage will increase your long term results (imagine if Buffett had used leverage prudently), you ought to use it.




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