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By David Kathman, CFA, Ph.D. | 10-02-98 | 12:00 AM | Email Article
about the dangers of leverage.
David Kathman, CFA, Ph.D., is a senior analyst on Morningstar’s manager research team.

Last week's near-collapse of the multi-billion-dollar hedge fund was caused by a variety of complicated factors that observers are still trying to sort out. Yes, some of Long-Term's exotic investments aren't the kind that most of us are ever likely to make--bets on interest-rate spreads between European bonds, for example. But the fund's real undoing was the excessive amount of leverage it used in its positions, and leverage is a concept that's important and relevant for even the smallest investor.

Leverage increases the potential returns on each dollar invested, but also increases the risk. Buying stocks on margin is one form of leverage. When buying on margin, an investor puts up a certain percentage of the purchase price (at least half, according to current regulations) and borrows the rest from a broker. Suppose you put up a $50 margin to buy $100 worth of stock; that means you're leveraged 2 to 1, or you control $2 worth of stock for every $1 invested. If the stock price goes up to $110, you can sell your shares, use $50 to pay back the broker, and be left with $60, including $10 in profit. Even though the stock only went up 10%, leverage got you a 20% return on your original $50 investment ($10/$50). The downside is that leverage also magnifies the potential losses just as much as the gains. If the stock had gone down 10%, you still would have had to pay back $50 to the broker, but your original investment of $50 would be reduced to $40, a loss of 20%.

As the secretive inner workings of Long-Term Capital were exposed, it became clear that the fund's impressive 40% annual returns were the result of rather ordinary investments juiced up by some industrial-strength leverage. Most of this was in the form of various kinds of derivatives; these generally require much lower margins than the 50% from the above example, which increases the leverage correspondingly. For example, the S&P 500 Index futures contracts sold at the Chicago Mercantile Exchange, one of the most popular derivatives on the market, only require a 5% initial margin. That means an investor can get 20-to-1 leverage, controlling securities worth 20 times the actual cash investment.

But because of its reputation and connections, Long-Term Capital was able to leverage itself much more than that; estimates over the last week have ranged from 30-to-1 to 300-to-1. As long as the markets behaved like Long-Term Capital's computer models said they should, that kind of leverage helped produce outsize returns. But once fallout from the Asian crisis caused the markets to deviate from expectations, that leverage became an albatross, and the fund found itself owing billions of dollars to its creditors. Only some fancy footwork involving infusions of cash and waiving of margin requirements kept the fund from going completely under.

The example of Long-Term Capital Management may be an extreme one, but it should serve to remind us that leverage is important for stock investors too. Businesses have to decide how leveraged they want to be, and just as in the securities markets, increased leverage increases both potential profitability and risk. One common measure of a company's leverage is debt/equity ratio, which is long-term debt (or debts not due to be paid within a year) divided by equity (or assets minus liabilities). Since interest on debt is a fixed cost, it doesn't rise when revenues increase, resulting in fatter profits. But that debt also has to be serviced when revenues go down, just as the broker in our hypothetical example above has to be repaid $50 no matter what the stock price does.

Companies with relatively stable revenue streams can afford to have more leverage than those with more erratic income. Leverage is particularly dangerous for cyclicals, whose revenue and earnings tend to rise and fall with the general economy. When times are good, as they have been for the last several years, leverage can boost the profitability of cyclicals. But when a recession hits, revenues for such companies drop off significantly, and leverage makes the problem worse. That's what happened in the early 1990s to Gehl, a small maker of construction equipment. The company grew rapidly in the late 1980s, borrowing lots of money to fund its expansion. But when recession hit in 1990 and Gehl's revenues fell, this leverage pushed the company to the brink of bankruptcy. It survived that scare and is now doing well again, though with much less leverage than it had a decade ago.

Sometimes companies deliberately use leverage in an attempt to magnify returns. That's happening right now with cell-phone maker CommNet Cellular. This company had posted lackluster returns for several years, but at the beginning of this year merchant bank The Blackstone Group bought 87% of CommNet and proceeded to leverage it to the hilt, cranking up its debt-equity ratio from 0.5 to 4.0. That strategy helped CommNet ride the first-quarter bull market and more than double its share price between the beginning of the year and early May. But when the market plunged, so did CommNet, and the stock now trades about where it did before the buyout.

Leverage can be a good thing for both investors and businesses, but it's important to be aware of the very real dangers involved. It's true that external forces bailed out Long-Term Capital this time, but the fund's troubles are still a stark reminder that as far as the market is concerned, the risk-reward tradeoff is the same for Nobel Prize winners as it is for you and me. In order to get those eye-popping returns, it's necessary to assume the risk of equally eye-popping losses.
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David Kathman, CFA, Ph.D. does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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