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.
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.
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.
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 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.