Leverage - A double edged sword!

Leverage is a neutral tool available to the investor. It neither favours helping the investor nor harming him. It is a double edged sword. The outcome of using leverage depends on how it is being used by the investor. So, the investor solely controls and is responsible for the outcome of using leverage, whether leverage will help or harm him.

Leverage is powerful in magnifying returns for the investor when it is used in certain situations and on the other hand destructive in magnifying losses when used in uncertain situations. Thus, leverage is a double edged sword and the wielder of this sword has to be trained in understanding how the sword can be used safety so as to help an experienced and knowledgeable wielder of the sword and not harm an unwary novice wielder instead.

One situation that poses uncertainty in using leverage is in trading of stocks. Stock prices fluctuate and when an investor is taking a position to long a stock or short a stock, there is no certainty that the stock will indeed rise (in the case of longing) or fall (in the case of shorting). No matter how an investor can boast of using technical analytic tools as a basis to enter into a trade, there is no absolute certainty that he can always have his way in terms of predicting the exact movement of a stock price. Thus, we hear of the saying "stop loss" and "cut loss" which are simply measures to minimise the impact of loss due to a stock price moving contrary to what is expected by an investor. In such uncertain situation of stock price movement, there is a hidden potential of leverage unleashing it's destructive nature despite having "stop loss" and "cut loss" measures in place as an investor cannot control stock price movements. As soon as a loss is incurred no matter big or small, leverage will magnify the losses further. 

However, in special situations such as a high probability of an arbitrage deal being completed, much risk would have been removed though a small risk that the deal may not be completed is still inherent as one cannot remove all risks. In addition, the more certain an investor can ascertain the time of completion of an arbitrage deal, he will be able to determine his adjusted projected annual rate of return (see previous post "A look at arbitrage deals using arbitrage risk equation from Benjamin Graham."). Using leverage in such certain arbitrage deal situations will help to magnify the returns for an investor.

I shall present here an example of how leverage can be used in such certain arbitrage deal situations. ABC company offers to buy all shares of DEF company at $10 per share in an acquisition exercise. DEF company agrees to tender all it's shares to ABC company at this price. Public announcements have been made by both companies and many investors of DEF company have tendered their shares and there is no objections from any major investors to block the acquisition. The acquisition exercise is expected to close in four months. Immediately after the public announcement, shares of DEF company are trading at around $ 9.70 per share.

For an investor who bought DEF shares immediately after the public announcement at around $9.70 per share, he will stand to make a return of about 3% in four months when the deal closes. His annual rate of return will be approximately 9%.

                                         = 3% in four months

                                           Annual rate of return = 3 X 3% = 9%

An annual rate of return of 9% may not make this deal overly attractive. However, the situation becomes different when leverage comes into the picture. Imagine that an investor can finance the buying of shares of DEF company at 8% borrowing interest rate per annum. This equates to a borrowing interest rate of around 2.7% for the four months period of the arbitrage deal. This translates to an interest cost at around $0.27.

Interest cost for the four months = 2.7% X cost of shares
                                                         = 2.7% X $9.70
                                                         = $0.27

Having an interest cost of around $0.27 per share and a potential profit of $0.30 per share from the arbitrage deal ($10 - $9.70 = $0.30), there will be a projected profit of $0.03 per share ($0.30 - $0.27 = $0.03).

Note that the cost of a share of DEF company is $9.70 per share, but the investor using leverage is borrowing this $9.70 at an interest cost of $0.27. So, his real investment cost is only $0.27 per share. He will earn a projected profit of $0.03 per share from our earlier calculations.

Thus, his rate of return for the four months is approximately 11%.

                                                                                    = 11% for four months

This translates to a whopping annual rate of return of 33% (11% X 3 = 33% in a year). With leverage, the investor can receive an annual rate of return of 33% compared to without leverage at an annual rate of return of 9%. His actual rate of return in four months time from the arbitrage deal is also higher at 11% with leverage compared to 3% without leverage. In this case, using leverage will approximately triple his returns in the same time period.

In conclusion, certainty when combined with leverage greatly magnifies returns for an investor. When leverage is used in certain situations such as a very high probability of consummation of an arbitrage deal within an announced known time period to completion of deal, an investor can determine his projected profit for the time period with high certainty. Leverage can thus be used as a powerful tool to greatly magnify an investor's returns in situations of high certainty. Wield this double edged sword properly with understanding and knowledge and it will greatly reward it's careful user.  

Leverage - A double edged sword!

To the knowledgeable wielder who wields the sword (leverage) with understanding, it rewards him greatly!

A look at arbitrage deals using arbitrage risk equation from Benjamin Graham.

There is a class of investors known as arbitrageurs who invest in arbitrage situations. There are two general types of arbitrage namely "market arbitrage" and "time arbitrage".

For market arbitrage, arbitrageurs seek to profit from price differences in the same security or investment being traded in two different markets. For example, if a company ABC's stock is concurrently being listed and traded in the London stock exchange at $10 per share and the Paris stock exchange at $12 per share, arbitrageurs will step in to sell the ABC's stock at Paris stock exchange while at the same time buy the stock at London stock exchange in order to pocket the profit of $2 per share in price difference. By the act of arbitrageurs, it is rare to see large price differences in any security or investment traded concurrently in different markets since any price differences will be immediately capitalised by arbitrageurs to profit from the price difference and thus the stock price of the same security will be brought towards approximately the same price by selling in one market and buying in another market simultaneously.

For time arbitrage, investors are arbitraging the price difference between what the stock price is today to what it will be at a future time. Many investors are already doing time arbitrage when we seek to buy a stock at today's price and hopefully sell it to another investor who will pay a higher price for the same stock in future (longing a stock) or borrowing and selling a stock at today's price and buying back the same stock at lower price in future (shorting a stock). The future time to fully transact an arbitrage in this case can be as short as one day to months or years.

Time arbitrage (longing shares - buy low sell high, 

or shorting shares - sell high buy low)

There are also special situations that will create arbitrage opportunities for the investor. These situations include mergers and acquisitions, securities buybacks or self tender offers, corporate reorganisations, corporate liquidations, corporate spin-offs and corporate stubs. With every potential arbitrage opportunity that comes on scene, there is also an element of risk that the arbitrage deal may not follow through to the end. An arbitrage deal that is created but does not follow through in the end may spell losses for investors who have invested their money into the deal to find that the deal does not work out. Thus, it is important to assess every arbitrage situation carefully to minimise the probability of entering into a losing deal.

Benjamin Graham, Warren Buffet's mentor and friend has an equation that can be used to assess the rate of return based on factoring in risk and reward of an arbitrage situation.

The first part of the equation is to determine the projected profit from an arbitrage situation (e.g. ABC company has announced a tender offer to buy all of DEF company's shares at $10 per share. DEF's shares are currently trading at $9 per share.)

Thus, the projected profit is $10 - $9 = $1 per share.

Next, we determine the probability that this tender offer deal will follow through to completion. Let's say there is a 90% chance of this deal completing. Note that the determination of the probability of the deal completing is more of an art than science since the investor has to assess all information available to him on the arbitrage situation carefully and come to a meaningful conclusion. His probability may differ from another investor's probability due to different views on the same arbitrage situation. We multiply our probability by the earlier projected profit.

Thus, the adjusted projected profit = 0.90 X $1 = $0.90 per share.

Next, we factor in the risk that the deal may fall apart and assume that the share price will return to the trading price before announcement of the tender offer. The risk is a projected loss between the current share price we pay and share price before announcement of tender offer. The current share price is at $9 per share for DEF's shares. Let's say the share price was $8 per share before the announcement of the tender offer.

Thus, the projected loss is $9 - $8 = $1 per share.

Next, we determine the adjusted projected loss. Since there is a 90% chance of the deal completing, there will be a 10% chance of the deal falling apart. We multiply this probability by the earlier projected loss.

Thus, adjusted projected loss = 0.10 X $1 = $0.10 per share.

Next, we determine the risk adjusted projected profit (after factoring in the risk involved in making the profit) by subtracting our adjusted projected loss from adjusted projected profit.

Thus, risk adjusted projected profit
         = adjusted projected profit - adjusted projected loss
         = $0.90 - $0.10
         = $0.80 per share

Lastly, we calculate our risk adjusted projected rate of return (in %) by dividing the risk adjusted projected profit over our original investment of $9 per share if we were to buy DEF's shares to enter into this arbitrage deal.

Thus, risk adjusted projected rate of return
          = ($0.80 / $9) X 100%
          = 8.9%

An 8.9% return on this arbitrage may not be too attractive over a year. However, if this arbitrage deal can be fully completed and the investor gets his profits in shorter time of six months, then the annual rate of return becomes 8.9% X 2 = 17.8%. This postulated annual rate of return is assuming that the investor can continue to keep his original capital reinvested after completion of the arbitrage deal at the same rate of return (for next six months to make up a full year). An annual rate of return of 17.8% now becomes attractive for an investor. Thus we see that an arbitrage deal becomes attractive should the arbitrage be completed in as short a time as possible.

In using this arbitrage risk equation, one is not trying to be precise in determining the rate of return on the arbitrage as no one can predict perfectly the outcome of any arbitrage situation. Therefore, the principle is to invest in arbitrage deals that have a very high probability of completion. One can be more certain of an arbitrage deal being completed if public announcements are already made and legal documents have been filed to the relevant authorities of securities exchanges.

As an arbitrage deal becomes more certain of being completed with passage of time, the gap in the traded share price to the tender offered share price (for example in the case of tender offers) closes and the traded share price in the open market will come close to the tender offer share price. The careful investor who waits for certainty before commiting his capital into buying the shares will see lesser rate of return.

However, an investor can still magnify his rate of return by using leverage (buying shares on margin) on such certain arbitrage deals. This is where the use of leverage (conventionally thought to be dangerous and destructive) works well in such certain deals to magnify returns. By combining certainty with leverage, this certainly beats uncertainty in the earlier stages of arbitrage when an investor buys on rumors and risk having the arbitrage deal falling apart and the loss on his capital.

How great leaders inspire action? People buy the "why" more than the "what" and "how".

The title of this post sounds confusing. It is meant to be confusing until you have watched the youtube video at the end of this post. The lessons learnt in this video can be applied to leadership, marketing and life. In leadership, people follow great leaders who know the purpose of "why" he is leading his people, to fulfil a great meaning and vision. The followers understand "why" they want to follow the leader. They are not just only following "what" the leader asks them to do, and the methods ("how") they are going to do certain things. Beyond all that, followers of great leaders know "why" they are following their leaders.

As such, great leaders inspire their followers by making them understand "why" they are following the leaders to fulfil a great meaning and purpose that speaks to their hearts. Once the followers understand "why" they are following a great meaning and purpose do the nitty gritty details of "what" they should do and "how" they should go about fulfiling that great meaning and purpose come about naturally with passion.

How many of us often heard our bosses telling us straight in the face to get certain things done and the methods we should pursue to get things done? How often if any at all do our bosses speak to us about "why" it is so important to do the things we do? Why do we need to work hard on a certain project? Is there a great meaningful purpose behind the project other than to benefit the company with improved sales and profits? Instead of looking only at profits alone, why not question whether doing certain things by a company serve any great meaning and purpose?

A great enduring company looks at a strong meaningful purpose and vision as a foundation to why they exist. They question the reason "why" they exist, to serve a greater meaning and purpose more than just being profits driven alone. A great healthcare company looks to serve their patients in terms of providing premium products and healthcare services to cater to their unique individual needs. This is the importance of questioning the "why" and not just the "what" and "how"(in terms of what medical treatment packages or healthcare products are available for sale and how to make the customers buy the services and products). By answering "why" customers should buy a product or service, a company can better innovate and market it's products and services to answer to the needs of it's consumers instead of convincing the customers to buy into the various features of a product or service that they may not have any needs for.

In marketing terms, the marketer should look to connect with the needs of the buyer. People do not care what you offer until you show you really care. This involves looking beyond the "what" (e.g. What products and services am I offering?). This also involves looking beyond the "how" (e.g. How can I market my products and services to make it attractive to my potential clients?). Instead, it instantly connects if the salesperson speaks to the needs of the potential buyer. For example, an insurance agent first gets to know the client well enough by questioning and listening to understand where are the needs of the client and why the client will need certain products or services before offering him the relevant insurance products and services that can meet his client's needs. The agent is not trying to convince his potential client of the good features of his products and services, but is only offering relevant products or services he believes can help answer the specific needs of his client.

In all the decisions and actions, this insurance agent is questioning "why" his potential client should buy certain products and services from him. He also understands fully and cherishes the meaning and purpose of "why" he is doing his trade. He does not see his trade as just a day job, but the job offers him an opportunity to fulfill a great meaning and purpose to help as many people he will meet. He hopes to help all his clients become financially better and also insured appropriately so that his clients' own and/or related family's future financial needs are covered against any unforeseen circumstances that threatens the basic survival of the client and/or family. He is working hard to meet the needs of his clients simply because he believes what he is doing will benefit as many people as possible instead of seeing it as only meeting his monthly sales targets and commisions. He is not constrained by only the "what" and "how" in his trade, but is inspired by the "why" of doing what he does.

Many great inventors also cherish the question "why" they are working on any great ideas. The Wright brothers set their dream on seeing man take flight opening another new method of travel never before when they invented the very first prototype of the more advanced airplanes we see in modern times. They persevere despite many failures until eventual success. "Why" do they persevere? They believe their dream of one day seeing man take flight into the air will change the course of the world. In the words of Orville Wright, "The desire to fly is an idea handed down to us by our ancestors who, in their grueling travels across trackless lands in prehistoric times, looked enviously on the birds soaring freely through space, at full speed, above all obstacles, on the infinite highway of the air."  

Perhaps it is time to ask ourselves "why" we do certain things in life. It is important to reflect every now and then on "why" (the meaning and purpose) we are working on certain things to inspire our actions - the "what" and "how" things can be done. Asking the question "why" works in leadership, marketing and all we do in life. By asking "why" each time, one can be inspired to persevere in fulfilling  great and meaningful purposes in life for ourselves and people around us. 

  

Does growth adds value or destroys value?

All businesses experience growth. If a business does not grow at all to aspire towards becoming a market leader, it is just a matter of time when a competition catches up and takes over the competitive advantage of an existing business. Some companies grow for the better creating more wealth and shareholder value while other companies destroy wealth and shareholder value as they grow. Thus, there is nothing great about growth if growth does not create more wealth and value.

How do we distinguish good growth from bad growth? To understand the distinction, we look first at a company with balanced growth. A company with balanced growth will increase it's revenue and other items in the financial statements such as net income, equity, liabilities and total assets at the same percentage every year. This means that the ratio of such important items in the financial statements to revenue remains the same every year. Other metrics like net profit margin and return on equity remains constant.

For a balanced growth company, the steady increase in revenue and net income makes the company more valuable through the years. However, the trade off is that the company has to maintain this growth with new capital every year that grow at the same rate as the growth in revenue and net income.

A typical balanced growth company has the characteristics on it's financial statements as follows. To make things simple, this company is assumed to be without debts and has only equity as the sole consideration for it's capital invested.

For this example of a balanced growth company, revenue, net income, equity and the amount distributable to shareholders (amount distributable to shareholders is calculated from net income minus additional required capital investment in the form of equity) all grow at similar rate of 10% per annum. Net profit margin and return on equity are relatively constant at 10% and 20% respectively.

To calculate the present value (PV) of the distributable cash flow to shareholders, one can use the formula as follows.

PV = C X [(ROC - G) / (R - G)] ,

C is the amount of capital at the start                                      

ROC is the return on capital

R is the cost of acquiring capital

G is the rate of growth

For this balanced growth company, it's return on capital (ROC) is 20% (same as it's return on equity) since it is assumed to have only capital in the form of equity and no debts. It's capital at the start (C) is the equity it has which is $100 million. It's rate of growth (G) is 10% since it grows it's revenue and net income at 10%.

Where growth does not add value nor destroy value

For the case when the return on capital (ROC) is equal to cost of acquiring capital (R) (e.g. both ROC and R are 20%),

PV = $100 million X [(0.20 - 0.10) / (0.20 - 0.10)]

      = $100 million

Thus, the present value (PV) of the distributable cash flow to shareholders ($100 million) is the same as the amount of capital invested by shareholders at the start ($100 million). The shareholders do not get more in present value of distributable cash flow as compared to their capital invested at start. This means that the company does not add value nor destroy value for it's shareholders even with a 10% growth rate of it's revenue and net income.

Where growth adds value

For the case when the return on capital (ROC) is more than the cost of acquiring capital (R) (e.g. ROC at 20% and R is 12%),

PV = $100 million X [(0.20 - 0.10) / (0.12 - 0.10)]

      = $500 million

Thus, the present value of distributable cash flow to shareholders ($500 million) is higher than their capital invested at start ($100 million). This means the company adds value to it's shareholders even with a 10% growth rate of it's revenue and net income.

Where growth destroys value

For the case when the return on capital (ROC) is less than the cost of acquiring capital (R) (e.g. ROC at 20% and R at 22%)

PV = $100 million X [(0.20 - 0.10) / (0.22 - 0.10)]

      = $83.3 million

Thus, the present value of distributable cash flow to shareholders ($83.3 million) is lower than their capital invested at start ($100 million). This means that the company destroys value to it's shareholders even though there is a growth rate of 10% in revenue and net income.

Conclusion

It is time to debunk the belief that all growth creates value for shareholders. Growth of a company usually requires some amount of additional investment of capital (be it in the form of equity or debts). Financiers of equity or debts will require their interests or returns on their capital provided to the company. This is the cost of acquiring capital the company has to bear in order to allow growth to be possible. When a company requires a higher cost of acquiring capital compared to the returns on acquired capital in order for growth, then growth may not be that good afterall since it destroys value for shareholders. Thus, the next time a company speaks of magnificent growth plans, it is time for a potential investor to look deeper into whether growth does creates value or not.

Termite infestation, a case where rapid growth destroys value.