Risk and The Many Forms of Leverage

Investment Analysis Clubs Saul’s Investing Discussions
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A while back someone compared Tesla and Shopify as being similarly overvalued which I completely disagreed with because of how “safe” I considered shopify vs tesla. The fundamental reason for my disagreement was leverage. I know when I started out investing I didn’t realize the ways company use leverage and how dangerous leverage can be. The following is my very simply working framework of leverage and how it relates to risk. I know that one could write whole chapters on each type of leverage below but I’ll doing my best to simplify.

So what is leverage? I think of it as anything that allows a company to “borrow” capital or allows the company to do more with less capital. I know this is a very fuzzy definition but I think it will make sense as I describe types of leverage below. I know the invesment community has a stricter definition which i’ve copied and pasted from investopedia. Investopedia defines leverage as, “Leverage is the investment strategy of using borrowed money: specifically, the use of various financial instruments or borrowed capital to increase the potential return of an investment. Leverage can also refer to the amount of debt used to finance assets. When one refers to something (a company, a property or an investment) as “highly leveraged,” it means that item has more debt than equity.”

The investing professionals measure “risk: with the sortini or sharpe ratio. Both of these are just measure of how much randomness your portfolio has in it. Randomness and volatility are for our purposes the same thing. I think that calling this measurement, “risk” is unfortunate as it confuses what risk really is. Ultimately we shouldn’t care so much about volatility but rather the risk that a company(not stock) underperforms or goes bankrupt. There are many different types of risk but one of the major things I have seen in my investing career is when a company has liquidity issues. It could be the best company in the world but if they don’t have cash to pay their bills they are going to have serious issues. I like to invest in companies with minimal risk, personally I don’t care about stock price volatility.

Leverage is something all companies use but some use it in a very dangerous way. Others use it in a way that basically ensures the leverage can’t damage them unless their fundamental business breaks down and the company wouldn’t be viable anyways. Leverage can be very powerful and allow a company to grow much more quickly than they could otherwise.

Debt
General debt is the most obvious form of leverage. All companies that I can think of use debt in various ways.
Bonds - company sells debt on an open market. Investors bid on it and the bond pays out some set percentage. The danger of bonds to a company is that for the most part the company is required to pay that percentage no matter the business conditions. This can be a very inexpensive way for a company to get working capital but I think bonds are pretty darn dangerous for companies if they aren’t really really careful. Everything can be going along 100% fine but then market conditions change and now the company is saddled with a payment they can’t really make go away.
Revolving Credit lines - Companies usually have a credit line to make sure they don’t have a liquidity crunch. Lets say you are in a business where you get lumpy payments, some quarters you have lots of cash, others not so much. Enter a credit line. In general these are just a part of business. What you want to watch out for though is when a company starts to use the credit line for large capital upgrades instead of just the day to day business cash flow needs. These are credit cards of the enterprise world. Generally expensive debt.

Accounting leverage
I wasn’t totally sure what to call this. Analysts will talk about the cash conversion cycle, days payable outstanding, days sales outstanding, and days inventory outstanding. The idea is to take as long as possible to pay something vs collecting money as quickly as possible. A while back Saul posted about how a grocery store can make money with such slim margins. Basically the store buys something but has 90 days to pay for it while when a grocery store customer buys that thing they pay for it immediately. Tesla is an interesting case study for this. They have about 90 days to pay most of their suppliers but they sell or even presell cars to customers before they are even made. In essence the customers and suppliers are providing leverage to the company. What happens if either side lose faith in the company? Lets say the suppliers become worried that tesla won’t pay so they require the company to pay for the supplies when it orders. In a capital intensive business like telsa that would mean BILLIONS of dollars in payments sooner than expects and if a customer says they will only pay for the car once it is delivered then that is tons of money that tesla doesn’t have access to leading to a classic liquidity crunch.

Leases
Leasing equipment and property is another form of leverage. Most of the time this is a very minor part of a company’s expenses although there has been a trend toward companies leasing integral parts of their business from other companies. For example there is a company called CorEnergy Infrastructure trusts that buys energy companies critical infrastructure and then leases that infrastructure back to the companies. Essentially providing leverage to those companies. I don’t see this being an issue for most of our companies.

Equity Dilution
Equity issuances and shareholder based compensation(SBC) are yet another way companies can get capital. The nice part about this for the companies is they have no real payments to worry about so it doesn’t limit their cashflow. Share issuances, and SBC come out of our pocket as shareholders but allow for much more resilient companies that don’t have the drain of debt payments on their cashflows. One just has to be sure that they companies are frivolously using our money as their personal piggybank.

So back to shopify vs tesla. Tesla uses large amounts of accounting leverage, large amounts of debt, don’t know about leases, and lots of equity in a very capital intensive business vs Shopify which has no real debt, no real accounting leverage, no real leases, but does use quite a bit of equity dilution in a business that doesn’t require much capital. This is why I am heavily invested in shopify and not in tesla.

Please chime in with thoughts or disagreements! This list is by no means complete. I’m sure I’m missing a ton.

best,
Ethan

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I think risk with Tesla and Shopify are in different categories and timespan. Making the big assumptions that they don’t go broke, make an Edsel style mistake, Musk does not crack up, Tesla will be lots bigger in a decade
With Shopify it is more the risk of running out of clients or being disrupted, these are less clear risks, thus the path is also less clear.
IOW while I can see how Tesla could produce 10 times more cars the path to shop selling 10 times more product is more murky.

I agree that Tesla is riskier, but those risks can be seen coming. OTOH making cars is m not a good business, making them electric does not make it a much better business.SHOP seems a better business but the TAM is nowhere close to the money in 100 million cars sold per year.

Re equity dilution in SHOP, think it was a one time thing, get capital while it is dirt cheap.

I own both but a lot more SHOP.

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Somehow I messed up the title. It was supposed to read, “Liquidity risk and the many forms of leverage”.

Also I didn’t mention preferred stock. Some features of equity and some of debt. I’d rather a company issues preferred stock than debt for the most part as generally companies can choose when to pay out the dividend thus being safer from a liquidity issue.

Mauser, SHOP has ongoing dilution with the amount of stock based compensation they are doing. I’m not saying it is a bad thing, just something to be aware of.

If telsa can navigate their upcoming liquidity issues then maybe they will succeed. Lots of headwinds for them.

best,
e

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So what is leverage? I think of it as anything that allows a company to “borrow” capital or allows the company to do more with less capital.

So is leverage a “dirty word” to be avoided at all costs?

How about taking out a mortgage to buy a home?

Or a loan to buy a new car? Or an old car?

Or signing a 1 or 2 year lease to move into an apartment?

How about using a credit card?

All these things are leverage. Or should we all move into caves and rub two stones together to make a fire to cook tonight’s meal that you just brought home from today’s hunt?

b&w

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buyandwin I don’t think Ethan suggested that leverage was a dirty word. He just gave a good definition of various types of leverage which I found informative. Obviously there is a certain level of risk with any leverage. When you take out a mortgage you risk loosing your home if, for what ever reason, you can’t make the mortgage payments etc.
Leverage is just another factor to consider when investing as ethan pointed out.
Mike

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There is another form of leverage. For companies that has large and ongoing infrustructure. This is deferred maintenance.

AT&T is a prime example of this. Airlines do it also.

This typically happens when a company has declining top line revenue and increasing profits.

Cheers
Qazulight

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Qazulight, that is a great one. Thanks!

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There is another form of leverage. For companies that has large and ongoing infrustructure. This is deferred maintenance.

AT&T is a prime example of this. Airlines do it also.

This typically happens when a company has declining top line revenue and increasing profits.

Are you at least able to keep the fiber safe?

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So is leverage a “dirty word” to be avoided at all costs?

How about taking out a mortgage to buy a home?

Or a loan to buy a new car? Or an old car?

Or signing a 1 or 2 year lease to move into an apartment?

How about using a credit card?

All these things are leverage. Or should we all move into caves and rub two stones together to make a fire to cook tonight’s meal that you just brought home from today’s hunt?

b&w

Leverage is just one aspect of risk. By itself, it increases risk while also increasing the potential reward. As you point out, a home is typically a highly leveraged asset (traditionally only 20% down with 80% borrowed or even more these days) and people found out during the real estate collapse that this does increase its risk. But there are other elements to risk including volatility. Housing prices have typically not been nearly as volatile as the stock market or an individual stock. The leverage used in buying a home is usually very reasonable for this reason. But using that degree of leverage in the stock market would be insanely risky. A smaller amount of leverage (perhaps up to 10-20% on margin) is not unreasonable but increases risk. So a combination of leverage and volatility increases risk. And the degree of both matters. Using a credit card prudently and paying off the balance every month is not risky. Maxing out multiple high interest credit cards and making only the minimal payment every month would be very risky to your financial health.

But there are other elements of risk associated with individual stocks. Company debt (a form of leverage) increases this risk. Valuation multiples also correlate with risk. As for TSLA, I think it’s extraordinarily risky given its valuation, unpredictable growth prospects and leveraged financial structure. It’s much riskier than SHOP. Just my two cents.

dave

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So what is leverage? I think of it as anything that allows a company to “borrow” capital or allows the company to do more with less capital.

So is leverage a “dirty word” to be avoided at all costs?

How about taking out a mortgage to buy a home?

Or a loan to buy a new car? Or an old car?

Or signing a 1 or 2 year lease to move into an apartment?

How about using a credit card?

All these things are leverage. Or should we all move into caves and rub two stones together to make a fire to cook tonight’s meal that you just brought home from today’s hunt?

b&w

I think you missed the point. Leverage is neither good nor bad. Too much leverage is bad… it becomes a house of cards. Too little leverage COULD mean passing up on opportunities. You tend to want companies using little, if any, leverage AND having high amounts of cash to use to expand.

M

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Housing prices have typically not been nearly as volatile as the stock market or an individual stock
they might be nearly as bad if they were repriced every second 5 days a week in a worldwide market like stocks .

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Housing prices have typically not been nearly as volatile as the stock market or an individual stock

they might be nearly as bad if they were repriced every second 5 days a week in a worldwide market like stocks .

A valid point

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So is leverage a “dirty word” to be avoided at all costs? How about taking out a mortgage to buy a home?

Hi buy&win,

Yes, leverage CAN be a dirty word. Here are two stories.

Some years ago, when I was living in a major city in Texas, there was a major real estate boom. Some friends, a couple who were in their late 30’s (a physician and an attorney), were flipping properties. What this meant was that they bought a property with 10% down (mortgage for the rest), in six months the value of the property rose 10% and they doubled their money and bought twice as much property (with 10% down). That’s using LEVERAGE! After five or six flips, doubling each time, they figured one more flip in six months and they’d sell everything and retire.

Well, suddenly the music stopped, and they couldn’t sell at any price. The prices dropped 20% and they were wiped out totally, lost everything they had and more, and had to file bankruptcy. I don’t know if they ever could retire. Yes, leverage can be a dirty word.

For something closer to home, Gaucho Chris wrote a post here: http://discussion.fool.com/conviction-can-be-dangerous-32756562… about how he got almost totally wiped out a few years ago using LEVERAGE!

In August of 2015 stocks started dropping and this was when I started adding leverage by taking out some debt against other assets (real estate); in addition, I began using bull spreads to invest more. As a result my portfolio was now leveraged…something that I had not done before in my many years of investing.

As my stocks dropped, I became more and more convinced that my stocks were a better bargain and I continued to add leverage as my stocks declined. By then end of 2015 by 70% gain had turned into a loss and in January 2016 the crap hit the fan. The unconceivable happened. Most of my stocks were down 30-60% from their August highs while then overall market was down less than 20%. This is something that I could not have imagined when I was adding to my positions in the late Summer of 2015. How could ALL of my stocks drop so much since I was diversified? Well, it happened.

Unfortunately, I could not ride out the decline in my stocks even though I was convinced would recover because the margin calls began. I was forced to liquidate positions in late January and February. The damage to my portfolio was severe, and I expect that I won’t fully recover to my August 2015 peak for another 3-4 years assuming that I continue to have good results going forward.

There’s nothing stupid about warning about leverage.

Saul

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Ethan,

Some other ways Shopify uses leverage…

** Shopify Capital. Shopify advances cash to merchants to accelerate the merchant’s
business hoping that will lever the use of Shopify’s services. The “interest” Shopify
receives for the loan is the discount they get on the customer’s future receivables. The
risks are the obvious ones, somewhat tempered by third party insurance.

** Deferred Revenue. The customer pays up front for future delivery of services. This is
really a loan by the customer to Shopify. That’s why it appears in the Liability section
of the Balance Sheet. The “interest” the customer receives is the discount off the monthly
price. Risks are the obligation to the customer and – from a cash standpoint – continued
customer acceptance of the subscription offering.

Using your very general definition – allowing the company to do more with less capital –
there is another huge form of leverage that Shopify employs. That form of leverage is the
implicit promise of many valuable birds in the bush in exchange for a bird in the hand. Shopify
can raise a significant amount of capital today because investors believe that someday
when they dominate the market they will have enormous profits. The risk comes from not knowing
the timing or magnitude of those profits – how many or how valuable those birds really are.
That’s one reason Shopify can be more risky than a company with conventional debt but predictable
profits and cash flow.

Ears

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Are you at least able to keep the fiber safe

Yes… but… Every inch
of the fiber for hundreds of miles, along with many regen huts and points of presence (POP). All the power, all the equipment, all the programming must work all the time.

Odds are agsinst us.

Cheers
Qazulight

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Ears, as always I find your posts thought provoking. I’m guessing my ratio of ear’s post read to recommended is near 100%. :slight_smile:

** Shopify Capital. Shopify advances cash to merchants to accelerate the merchant’s
business hoping that will lever the use of Shopify’s services

Yeah this is interesting because shopify is providing leverage to the businesses but since the businesses are their customers for their other services they are doubly exposed to downturn. I think I see your point in that shopify is juicing the merchants ability to grow by providing them with capital. I couldn’t find the particulars of the third party insurance. Do you have any info?

** Deferred Revenue. The customer pays up front for future delivery of services. This is
really a loan by the customer to Shopify

In my mind this is one of the least risky liabilities possible especially when the services (shopify) is so integral to the business. I’ve always considered this an asset of the shopify/SaaS business model. Do you feel otherwise?

That form of leverage is the
implicit promise of many valuable birds in the bush in exchange for a bird in the hand. Shopify
can raise a significant amount of capital today

I consider this the basic idea behind stock markets and investing. Thanks for adding that. I wish could go back and edit my original post to add that part.

Ears, I know this isn’t exactly on topic. I’ve followed your posts for a while now and I wonder; Are you sceptical of the SaaS business model? Do you mind if I ask what stocks you currently find attractive (from an investing perspective) ?

best,
Ethan

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B&W, your post made me go back and re-read what I had written! And while I do enjoy a good campfire I think Saul, remmdawg, and ProdigalFool17 did a good job clarifying what I was trying to say.

best,
Ethan

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I think you missed the point. Leverage is neither good nor bad. Too much leverage is bad… it becomes a house of cards. Too little leverage COULD mean passing up on opportunities. You tend to want companies using little, if any, leverage AND having high amounts of cash to use to expand.

I think the big problem is --since we are always looking back and know the result after it happened, it is very easy to find the culprit, and blame it on an obvious scapegoat “leverage” because we might not be aware of the true problem. For example --a trusted top salesman who was partying the night before an important presentation he was going to make with an important client. He shows up with a hangover and blows the presentation and the company doesn’t get the important contract that the company was spending money and gearing up for, and counting on for growing the future. They go downhill after that. Is that the fault of the leverage, or the drunken salesman?—Or just the combination of things and bad luck?

Someone in one of the posts mentioned Tesla. —Perfect example Easy answer–If they fail Blame it on the leverage. If it succeeds- than ELON is a genius.

So–to make money on this—Write two books and prepare them for publication

  1. Call the book–“Leverage And The Downfall of Tesla”
  2. Call the book–“ELON the Genius-And How He Made A Gazillion Dollars”

Then the day after the event happens, publish the correct book and you might become a Millionaire overnight

good luck

b&w

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So–to make money on this—Write two books and prepare them for publication
1) Call the book–“Leverage And The Downfall of Tesla”
2) Call the book–“ELON the Genius-And How He Made A Gazillion Dollars”

Or, as Orson Welles dramatically portrayed:

https://www.youtube.com/watch?v=9iMy0969BTw

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Housing prices have typically not been nearly as volatile as the stock market or an individual stock
they might be nearly as bad if they were repriced every second 5 days a week in a worldwide market like stocks .

“Typically” " not been nearly as volatile" “might be” “repriced every second 5 days a week”

You can tell those catchy phrases to the 1000’s of people that got foreclosed on, during the housing crisis a few years ago.

b&w

1 Like