Trailing an Index Return Isn’t Necessarily A Bad Thing: The Wreckage of Leverage
by A. Scott White, CFP®, ChFC, CLU
By most measures, as I write this article in the beginning of June 2014, I believe stocks that comprise the S&P 500 index are fairly valued, not greatly undervalued or overvalued. Some argue that with the Federal Reserve’s monetary policy designed to inflate asset prices, stocks should actually be trading at the higher end of their historic price range. The purpose of this article is not to predict if stock prices in general will go higher, but to suggest that stocks trading at these prices make the use of leverage awfully tempting for corporate leaders.
Leverage is a term used to describe borrowing money, and borrowing money has both positive and negative benefits. As a positive, if a corporation can borrow money for less than it costs the corporation to produce the money needed to fund its operations internally, the company is better off borrowing the money. On the other hand, most people understand if that one borrows too much money one can get oneself in trouble in a hurry. So where does this leave us today?
When companies emerged from the great recession of 2008-2009, money became very cheap with artificially low interest rates. Some companies took advantage of it responsibly. Corporate executives in the past few years have been very wary of the economy slipping back into a recession. This fear caused them to give much reservation when borrowing money. But today, many economists and business leaders are much less fearful that the economy will slip back into recession, and this creates the temptation to take on borrowing or leverage. Why? Simply put, if a corporation can borrow money for less than it costs it to earn money internally, the corporation can increase its profit margins to a certain extent by simply adding on leverage. In most cases, the increased profits mean higher stock prices. So if a company’s stock is fairly priced, management may feel lured into attempting to boost its stock price by increasing its use of leverage. This task is often much easier than finding new customers or creating new products to increase profits.
But the use of leverage can turn into an addiction. Just a little more won’t hurt…a little more leverage, no glitches in the economy, corporate profit margins up, stock price up, what’s the harm? Let’s do it again. Corporate executives sometimes convince themselves they can always unwind this leverage when the economy begins to deteriorate. So they continue adding on, year in and year out. What forces most addicts to stop their addiction? A crisis. The same is true with the corporate abusers of leverage. Just look at the latest recessions. Here the very people who claim to be so smart about the workings of the economy—the big banks, investment firms and insurance companies— are the very ones guilty of abusing leverage. And if these people who should be in the best position to anticipate a deteriorating economy failed so miserably at unwinding their use of leverage in time, what makes anyone think they can do it better?
At the heart of all great financial disasters is the abuse of borrowing. In the Great Depression of 1929, investors over borrowed on their margin accounts to buy more stocks. The dot com bust of 2000 when many technology companies had no profits, resulted in their funding growth by using other people’s money. The Great Recession of 2008, when the big banks and brokerage firms leveraged up their balance sheets with the use of collateralized mortgage-backed obligations, caused an unprecedented liquidity crisis.
What’s next? Perhaps government misuse of debt? I don’t know. And no one else knows either. But I do know this: When fear turns to greed, leverage will reign the day. A prudent investor will avoid the companies that are the abusers of leverage, and that will be emotionally difficult. Why? Because most equity indexes these days are made up of a broad cross section of corporate stocks. Many of the companies in an index will be the very abusers this warning is addressing. And if these abusers make up any substantial portion of an equity indexes, then these indexes could quite naturally perform better than the portfolio of an investor who avoids buying leveraged stocks. The pain the investor experiences when underperforming against an index return may be justified when the next unexpected economic crisis arises, and every economic crisis is unexpected. The companies that leverage up their balance sheets by borrowing money may not be able to unwind their debt in time and may become the wreckage of the crisis. And the investor who avoided the abusers of leverage may become part of the statistic that enjoys equities’ historically favorable long term returns.
Scott serves as a mentor to students who want to enter the financial planning field. Recently he met with Michael “Jake” Arden, as part of the Financial Planning Association’s “Shadow a Financial Planner” Day. Here Scott shows Jake how he reviews investment statements.
To raise money for the Fort Myers Rotary Club, Scott volunteered to park cars for the Boston Red Sox at City of Palms Park.
Scott hosted a seminar for clients on “The Truths and Myths of Home Care.” Stan Grigiski, Owner, Medical Claim Service of Southwest Florida, and Maureen Oravec, Territory Manager at Comfort Keepers, presented information.*
*Raymond James is not affiliated with and does not endorse the services of Stan Grigiski or Maureen Oravec.
The information contained in this report does not purport to be a complete description of the securities markets or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing materials are accurate and complete. Any opinions are those of Scott White Advisors and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date subject to change without notice. Past performance may not be indicative of future results. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Strategies discussed may not be suitable for all investors. Investing involves risk and investors may incur a profit or loss regardless of strategy selected. Diversification does not ensure a profit or guarantee against a loss. Commodities and currencies investing are generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising. Gold is subject to the special risks associated with investing in precious metals, including but not limited to: price may be subject to wide fluctuation; the market is relatively limited; the sources are concentrated in countries that have the potential for instability; and the market is unregulated.