Companies use leverage because it can boost earnings, and that's a good thing. But leverage is also bad because it increases the volatility of earnings and increases the risk of bad things happening such as rights issues, dividend cuts and bankruptcy.
The trick is to find companies with the "right" amount of leverage given your investment goals, and that requires the right tools for measuring leverage.
Measuring leverage in non-financial companies
Leverage in non-financial companies is definitely easier to get to grips with than it is for financial companies like banks and insurance companies.
For the sort of relatively defensive companies I'm looking for, those with consistent records of profitable dividend growth, it basically comes down to borrowed money. How much has the company borrowed and how does that compare to its ability to pay the interest on those borrowings in both good times and bad.
There are lots of different ways to approach this. Two of the most popular are:
- Interest cover, typically defined as operating profit divided by interest.
- Net debt to EBITDA, where net debt is total borrowings net of cash and EBITDA is earnings before interest, tax, depreciation and amortization.
Personally I don't use either of these because they rely on last year's earnings, which may not be a good guide to a company's typical earnings over a number of years.
Given that debts are likely to be carried for many years into the future I think it makes more sense to compare debt or interest to a company's average earnings over a number of years, in other words to its general "earnings power." The result should be a ratio which is more reliable and robust than those which depend on a single year's earnings.
So my rule of thumb for conservative leverage in non-financial companies, taking an average earnings approach, is:
Don't invest in a company if its total borrowings are more than 5-times its earnings power (defined as 5-year average adjusted profit after tax)
From experience, a ratio of 5 seems to be a reasonable figure which most companies can meet, but beyond which debt related problems begin to be more common.
I use profit after tax in the ratio rather than EBIT or EBITDA because it has interest removed, which will increase the ratio (and decrease the allowable debt) for companies that have to pay a higher interest rate on borrowed money.
And that's all I look at for non-financial company leverage. I don't look at debt to equity ratios or working capital ratios because in my experience they aren't that useful when applied to the sort of relatively defensive and successful companies I'm after.
You might think a single ratio like this would be overly simplistic, but having read up on research such as this Bank of England speech on the benefits of simple rules in complex and uncertain situations (aka The Dog and the Frisbee), I am quite happy to embrace simplicity.
As with any rule of thumb regarding which companies to invest in and which to avoid, there is a balance to be struck between excessive leniency and excessive caution. Of all the non-financial companies in the FTSE All-Share that have a 10 year unbroken dividend record:
- 16 have no debt.
- 141 have some debt, with an average debt to earnings power ratio of 2.4.
- 59 have a debt to earnings power ratio of more than 5.
Around three quarters pass the test, which leaves a reasonably large pool of companies for further analysis.
Measuring leverage in banks
Banks are different to normal "trading" businesses. They don't buy or sell services (or at least that isn't their core business), instead they borrow money from those who have it and then lend it on to those who need it.
Profits are primarily in the form of net interest income, i.e. the difference the interest income on loans and the interest expense on deposits. There's a bit more to it than that of course, but that's the basic picture.
So the entire business of a bank depends on borrowed deposits. The result is that most debt ratios (including the one above) are useless when analyzing banks because they make banks look hopelessly over-leveraged.
What we need is a bank-specific leverage ratio which will help us to make reasonable assumptions about a bank's underlying capital strength.
Fortunately it seems that banking regulators have caught onto this idea, as the new Basal III regulations stipulate, for the first time, a minimum leverage ratio for banks.
This leverage ratio is the ratio between the bank's capital and its exposure to risk. An important ratio has long been the "Tier 1" ratio, which comes in a variety of guises, the strictest of which is Core Tier 1, based on Core Tier 1 capital.
That's a pretty meaningless phrase to most people (including me before I started looking into this), but Core Tier 1 capital is basically a bank's highest quality assets which can used as a balance against lending and other risky banking activities.
Here are the Core Tier 1 ratios of some well-known banks:
- Barclays (OTC:BCBAY): 2007 = 7.8%, 2013 = 9.9%
- Heritage Financial Group (HBOS): 2007 = 7.4%, 2008 = 6% (subsequently "rescued" by a merger with Lloyds)
- HSBC (NYSE:HSBC): 2007 = 8.1%, 2013 = 12%
- Lloyds (OTC:LLYBZ): 2007 = 8%, 2014 = 11%
- Standard Chartered (OTCPK:SCBFF): 2007 = 9.8%, 2013 = 11.8%
As you can see, in the wild west days before the financial crisis most banks had lower Core Tier 1 ratios (or equivalents) than they do today.
But it's hard to see much of a difference between the banks that had major problems in 2007/8 with those that didn't. What was more important than leverage in the financial crisis was the kind of risks a bank was taking, and that's the sort of thing a simple ratio can't show.
However, this leverage ratio can still be useful if we look at its levels from before and after the crisis.
Before the crisis most banks had Core Tier 1 ratios below 10%; in other words they had less than 10p of Core Tier 1 assets for every 100p of risk exposure. After the crisis most have moved to ratios above 10%.
Of course they're being forced to increase capital and lower leverage because of tighter regulation, but regulations don't last forever, as we saw when the deeply useful Glass-Steagall Act was repealed in the late 90s, leading directly to the financial crisis.
So just in case the banks do decide to embark on another debt-fuelled feeding frenzy at some point in the future, I have started using the following rule of thumb for banks:
Don't invest in a bank where its Core Tier 1 ratio is below 10%
That could result in banks being off-limits as an investment for years or even decades at a time, but as the financial crisis showed, if can be very painful to be invested in banks at the wrong time.
And if a bank does make it past the test it will be very conservatively financed relative to recent history.
Measuring leverage in insurance companies
Unlike most banks, insurance companies do have a simple entry on the balance sheet called "borrowings", just like non-financial companies. This means the borrowings to earnings power ratio above can be used for insurance companies too.
However, there is another form of leverage that we should also be interested in.
Insurance companies work by pooling small amounts of money from lots of policyholders in order to pay out infrequent but large claims when they arise. This means they're usually sitting on a large pot of collected premiums which don't belong to them. This is often referred to as insurance "float."
This float needs to be enough so that all claims can be paid on time, in other words there needs to be a surplus of premiums over expected claims. If there isn't enough of a surplus then an insurance company may need to raise additional capital either through a bond issue or rights issue, neither of which is good news for shareholders.
So with insurance companies we want to be sure that the company has a more than adequate amount of surplus capital relative to the scale of its business.
One traditional measure for this is the premium to surplus ratio, which I'll define here as net written premium to shareholder equity (not including debt capital). You can find both of those in the company's accounts.
To get feel for what an appropriate ratio might be, here is the premium to surplus ratio for some leading insurance companies:
- Admiral (OTCPK:AMIGY): 2011 = 1.4, 2013 = 1.1
- Amlin (OTCPK:APLCY): 2010 = 1.1, 2013 = 1.4
- Aviva (NYSE:AV): 2000 = 2.1, 2011 = 3.5
- RSA (OTC:RSAIF): 2000 = 2.3, 2011 = 3.2
I chose the year 2000 as the date point for RSA and Aviva because both companies had a lot of problems shortly after the start of the millennium. Those problems were caused in part because they both had relatively weak capital positions compared to the amount of new business they were writing.
RSA and Aviva both had a premium to surplus ratio of more than 2 when they were hit by falling investment values after the dot-com boom. That weakened their capital position further (as their floats were partially invested in equities) which led to a major rights issue for RSA and a significant bond issue for Aviva.
More recently these two companies have run into problems again, and largely for the same reasons.
In 2011 Aviva and RSA still had premium to surplus ratios above 2 and shortly afterwards Aviva cut its dividend while RSA launched yet another rights issue.
Amlin and Admiral on the other hand have always had a premium to surplus ratio of less than 2, and both have been relatively free of the problems suffered by their more highly leveraged cousins (although Amin did suspend its dividend for a year in 2001, but that was due to losses from the 9/11 World Trade Center attack).
A premium to surplus ratio of 2 is an interesting cut-off point as several old insurance industry books mention it as a measure of conservative underwriting, and on the evidence above I'm happy to use the following rule of thumb:
Don't invest in an insurance company where net written premium is more than 2 times shareholder equity (excluding debt capital)
But there is another factor involved here too.
The strength of an insurance company's capital base is dependent on how much surplus insurance float it has beyond its expected claims. If the float is invested in risky, volatile assets then a surplus which looks fine this year can become dangerously thin if the risky assets fall in value.
As I mentioned above, this was another problem that RSA and Aviva suffered from in the early 2000s.
For years the insurance industry had lucked into massive investment profits from rising stock markets as their investment portfolios were allocated increasingly to equities.
In 2000, at the height of the dot-com bubble, many insurance companies, including RSA and Aviva, had too much of their float invested in overvalued risky assets.
The subsequent collapse of the equity markets from 2000 to 2003 increased RSA's and Aviva's already high leverage ratios to unsustainable levels, which led to large bond issues, major rights issues and dividend cuts.
Today the picture is very different. Comparing their equity investment allocation then and now:
- Admiral: 2000 (wasn't listed yet), 2013 = 0%
- Amin: 2000 = 17%, 2013 = 8.5%
- Aviva: 2000 = 30%, 2013 = 1%
- RSA: 2000 = 26%, 2013 = 4%
Insurance companies are far more cautious today than they were a decade or so ago. However, there are no guarantees that they won't slip back into bad habits if we have another long bull market in equities, so I'll be using the following rule of thumb:
Don't invest in an insurance company if it has more than 10% of its investment capital in equities
As with the banking rule of thumb, this may rule out investments in the insurance industry for long periods, but nobody ever went bust by not investing in insurance companies. What's more important is that only conservatively financed insurance companies make it into a defensive portfolio.
Finally, there is another piece to the puzzle of insurance companies. It doesn't directly relate to leverage, but it is important so I'll mention it here anyway.
As we've just seen, during the long boom in equity markets during the 1990s insurance companies were able to make huge amounts of money by investing their float in stock markets around the world.
In fact, they could make so much money through investments that they were willing to lose money on the underwriting side of their business just to get their hands on additional premiums to invest.
For example, if an insurance company writes policies with say £100m in premiums, but expects to have to pay out £105m in claims and £5m in expenses, it has made an underwriting loss of £10m and has a combined ratio (combination of claim and expense ratios) of 110%, where any ratio above 100% represents an underwriting loss.
However, if the company can generate a 20% investment return on that £100m then that would more than offset the underwriting losses and create a net profit.
That's basically what a lot of insurance companies were doing during the go-go days of the dot-com boom.
Here are some combined ratios for the same insurance companies we looked at a moment ago:
- Admiral: 2000 (not listed yet), 2013 = 89%
- Amlin: 2000 = 111%, 2013 = 86%
- Aviva: 2000 = 109%, 2013 = 97%
- RSA: 2000 = 110%, 2013 = 97%
During the late 90s stock market bubble RSA and Aviva were losing money on almost every policy they wrote, just so they could build up a larger float to invest at what they thought were going to be high rates of return.
Unfortunately for their shareholders it didn't work out that way.
They didn't have enough surplus capital to support the amount of premiums they were writing, and when the stock market bubble burst both companies saw their too-small capital bases shrink even further, which led to rights issues, dividend cuts and so on.
Amlin escaped that fate, but cut its equity exposure in September 2011 shortly after the 9/11 attack and focused instead on making money the old fashioned way, through sound and profitable underwriting.
So here is another simple rule of thumb to avoid insurance companies that are losing money on their core underwriting business:
Don't invest in an insurance company if its combined ratio is more than 99%
Banks and insurance companies can be horribly complex things to understand. However, the combination of these simple rules of thumb may help to reduce the time it takes to analyze them and ensure that only the most prudent financial and non-financial companies make it into a defensive portfolio.
Disclosure: I own shares in Standard Chartered, RSA, Amlin and Admiral (and I sold my Aviva shares at the start of 2014)
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