How Smart Investors Use ‘Good’ Leverage To Magnify Returns

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In his recent interview with Tobias, Dan Rasmussen, who is the Founder and Portfolio Manager of Verdad Advisors provides some great insights into how investors can use ‘good’ leverage to magnify returns. Here’s an excerpt from the interview:

Tobias Carlisle: Well, I think I’m agnostic to the leverage in the company, provided that the operating income is there to support it. It’s not excessively leveraged, but I have found, and you perhaps know better than I, whether there’s a tipping point where debt is good up to a point and then beyond that point it’s sort of deleterious to your return. So, do you want to talk a little bit about the sensitives of debt, how you sort of assess whether something is sort of a safe investment, and where you think that the limit might be?

Dan Rasmussen: Yeah, and I would say that the world of safe investments is not the world I play in. You know? I am on one end of the risk and volatility spectrum, and happily so. So, if you want safety, go buy bonds. Where our goal is to outperform and my view is that to outperform, you have to take risks. So, setting that aside, leverage. Leverage, more debt is bad. More debt is bad. If you measure debt as debt to assets, debt to EBITDA, debt to interest, any absolute value of metric, you’re gonna find that the more levered a company is, the higher the probability of bankruptcy. And bankruptcy is like getting a zero on your math test in eights grade, right?

Dan Rasmussen: One zero will sink your entire semester grades, so you don’t want zeroes. And debt is what creates the possibility of a zero. And so, what you find is that increasing leverage increases the risk of bankruptcy. Now, what you also find is that just like buying a home or any other asset, if you buy something well and let’s say you buy it for $100 and you borrow 90 of those dollars and you sell it for a $110, wow you made 100% profit on a 10% rise in values. So, leverage amplifies the returns. And so, what you find, I think, of leverage, is sort of a trade off; there’s good leverage which is leverage as a percentage of your purchase price right?

Dan Rasmussen: So, if you think you’re making a good investment, you’d ideally want it as levered as possible to magnify gains when it works. But, on the other hand, if you’re wrong, you want less leverage on an absolute basis. And so, that’s why the intersection of leverage and value is so important. If you buy cheap things with debt, you tend to have the advantages of the magnification and you don’t have too much bankruptcy risk. But, on the other hand if you buy expensive things with debt, you know, God love ya, it ain’t gonna turn out too well.

Tobias Carlisle: You have a nice strategy in that the debt is by virtue of the fact that it’s raise by the company, the target that yo put into the portfolio, it’s non-recourse to you, so it’s not like your carrying debt at a portfolio level. It’s carried up the holding level. So, in that instance, if you’re going to do it, that’s sort of the way to do it so that any individual stock that might fail doesn’t sort of risk the entire portfolio.

Dan Rasmussen: That’s right, and think you know, this is Robert Schiller won the Nobel Prize for the finding that market prices are 20 times more volatile than fundamentals. So, if you think about where you want leverage, you don’t want leverage on the really volatile price movement of a stock. You want leverage on the balance sheet of a company where it’s dependent on that company’s earnings. And what you find is that when you have leverage there, it’s asymmetric. So, if you say, have a margin loan, you have symmetric exposure. If the markets go up 10 then you’re levered 100%, you go up 20. And if it goes down 10, you go down 20.

Dan Rasmussen: If you buy a portfolio of levered companies, that are equivalently levered, you tend to not quite go up, if say 50% levered, or 50% debt, 50% equity, you don’t go up quite 100% when the market… you don’t up 2x when the market goes up, you go up a little less than that. But when the market goes down you don’t go 2x down, you go only little bit worse, because unless a bankruptcy risk of the company is meaningfully changed, the equity won’t reprice to reflect the fact that the company’s leverage is 50%. And that’s sort of the key insights to making this work.

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2 Comments on “How Smart Investors Use ‘Good’ Leverage To Magnify Returns”

  1. Great podcast, would be great if you listed the different research pieces mentioned during the podcast below the video, that would help your audience’s own research!
    Thanks

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