Tamara buys a stock market index (VTI) and reinvests her dividends. She doesn’t use leverage. She began investing exactly ten years ago, and has made 178% on her investments, for an annualized return of 10.76%. Her initial $100,000 investment is now worth $278,000.
Jessika buys the same stock market index and reinvests her dividends. But she does use leverage, at 1.5X, with a 10% margin carry cost and a minimum maintenance margin of 35%. You’d think she’d make quite a bit more than Tamara, right? But no. Starting at the same point in time as Tamara, she gets a margin call after seven months. And even if she had avoided that margin call in 2009, her total return is still only 172%, for an annualized return of 10.56%. Tamara still wins, because leverage is not cheap in this world.
What if Jessika had used 2X leverage? Her equity would have fallen below zero in March 2009. The only way Jessika could have made more money than Tamara is if there had been no margin call and her margin carry cost had been below 10%. But there’s a psychological cost to consider as well: the standard deviation of her returns would have been almost double that of Tamara’s.
If you make the right deal, leveraging your returns can be quite profitable. Let’s say that Jessika had found a broker that didn’t make margin calls, gave her 1.75X leverage, and charged only 2% interest. At the end of ten years, she would have made 259%, for an annualized return of 13.64%. Her initial $100,000 would be worth $359,000.
But finding a broker like that would have been very hard, if not impossible.
Jessika could, of course, have taken out a personal or home equity loan. The problem there is that she would have had to pay a portion of the total (loan plus interest) every month, and if her home equity loan had been big enough, she would have lost her house after seven months. If she had obtained a ten-year loan for $50,000 at 6%, putting the entire amount into VTI and paying $555 a month for the privilege, she would end up with $276,268 at the end of ten years, which is still lower than Tamara’s total.
What if Jessika had simply bought a 2X leveraged ETF like SSO instead? Well, she would have received a return of 323%, or 15.52% annualized, and her $100,000 would be worth $423,000. But she would have lagged Tamara for the first five years after her buy and suffered a drawdown of 77%. Using leverage is highly risky, and leveraged ETFs are not recommended for long-term holding.
I’m going to suggest a very different approach for Jessika. I’m going to suggest that she use leverage by investing in companies that are using their leverage wisely. To get leverage safely, invest in companies that use leverage, but make sure their earnings are high enough to cover their debts.
First, we need to define leverage. For investors, leverage is straightforward: it’s the sum of the amount you have and the amount you borrowed divided by the amount you have. If you have $100,000 and you’re borrowing $50,000, your leverage is 1.5X. Similarly, for a public company, leverage is total assets divided by total equity. But this isn’t nearly as straightforward, because there are plenty of companies with zero or negative equity. How do you measure their leverage?
Let’s look at it mathematically. Leverage = assets/equity, so 1/leverage = equity/assets. Since equity = assets – liabilities, equity/assets = (assets – liabilities)/assets = 1 – liabilities/assets. So leverage = 1/(1 – liabilities/assets).
Now liabilities divided by assets is what’s commonly known as the debt ratio. And it’s clear from the above formula that the higher the debt ratio, the higher the leverage. If the debt ratio is 0.5, leverage is 2X. If the debt ratio is 0.8, leverage is 5X. If the debt ratio is 0.95, leverage is 20X. And if the debt ratio is greater than 1, then leverage is off the charts.
Given this, I’ve designed an index for Jessica: the Leverage 100. These are the hundred stocks on the market with the highest debt ratios (and therefore the highest amount of leverage), so long as their price is over $1.00 per share, market cap is over $100 million, EBITDA is greater than zero, and debt-to-EBITDA is less than ten. (Just so that nobody accuses me of cherry-picking, these are nice round numbers and well-established criteria. And yes, I also wanted all the limits to be made up of 1’s and 0’s. Just for fun.)
(In case you’re unfamiliar with these terms, EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Debt-to-EBITDA is the ratio that banks and credit agencies look at when deciding if a company is borrowing too much. Companies with debt-to-EBITDA ratios over five often get lower credit ratings. All of the companies I’ve looked at whose bonds have CCC ratings right now have debt-to-EBITDA ratios of five or higher.)
With quarterly equal-weight reconstitution and 0.25% slippage costs, the ten-year returns of the Leverage 100 are impressive: 384%, or 17.09% annualized. Jessika would have made more money investing in this index than with any of her other options: her $100,000 would have grown to $484,000, leaving Tamara in the dust.
Do you want more than ten-year returns? Well, I can only backtest back to 1999, but the Leverage 100 has annualized returns of 14.03% since then, compared to VTI’s 7.04% (or the equal-weight S&P 500’s 9.02%). And if we reduce the number of stocks in the Debt 100 to the Debt 50 or the Debt 20 or the Debt 10, choosing the stocks with the very highest debt ratios, the ten-year returns go up: to 20.90%, 26.29%, and 30.45% annualized, respectively. (If you’d like to play around with this and you subscribe to Portfolio123, here’s the screen and here’s the simulation.)
What were these miracle stocks Jessika would have invested in? Seven stocks have been in the index for ten years running: Cincinnati Bell (CBB), Choice Hotels (CHH), Dennys (DENN), Dun & Bradstreet (DNB), Domino’s Pizza (DPZ), National CineMedia (NCMI), and Sally Beauty (SBH); AutoZone (AZO), Unisys (UIS), and Vector Group (VGR) have been in it almost as long. The current top ten are Domino’s (DPZ), Yum Brands (YUM), Wingstop (WING), Aspen Technology (AZPN), Nathan’s Famous (NATH), MSG Networks (MSGN), Weight Watchers (WTW), Mechel (MTL), Northern Oil and Gas (NOG), and Verisign (VRSN).
These high-debt-ratio companies are getting tremendous leverage. At the moment, every single stock in the Leverage 100 has a debt ratio greater than one, which means a practically infinite amount of leverage. Back in 2008, when Jessika was first investing, the Leverage 100 included 46 stocks with debt ratios less than one, so that you could quantify their leverage, which ranged from 16X to 2300X. But now, negative equity companies rule.
I should say a word or two about the negative equity phenomenon, which Travis Fairchild at O’Shaughnessy Asset Management has written about at length here. (I’ve also written about it at length here; this article explains why you should favor companies with high debt over companies with high equity.) Fairchild points out that negative equity companies have outperformed the market in 57% of rolling three-year periods over the last twenty-five years (unlike me, he includes companies with extremely low or negative EBITDA, which worsens his results). He rightly points out that some of the reasons these companies have negative equity are that their balance sheets understate the value of their intangible assets, that their long-term assets are depreciated too fast, and that their use of buybacks and dividends create a decrease in equity that can “accelerate distortions.” But what Fairchild doesn’t look at is these companies’ use of debt (and certain non-debt liabilities) as leverage to power their growth. In fact, the word “debt” appears nowhere in his paper.
Since negative equity companies have low total assets to begin with, it’s begging the question to use assets or equity in a measure of these companies’ debt. So let’s compare their debt load to their market cap instead. The median debt-to-market-cap ratio of the 126 negative-equity companies that currently have $100 million market caps and debt-to-EBITDA ratios under ten is 0.70; the median debt-to-market-cap ratio of the S&P 500 is 0.24, and the median ratio of the Russell 3000 is 0.25. By absolutely any measure, negative equity companies are awash in debt. And that’s why they thrive—not because their assets are understated.
As long as the debt-to-EBITDA ratio of these companies is reasonable, banks and bondholders are not going to be knocking on their doors for repayment. These companies have interest expenses, of course, but those expenses are usually pretty modest. The median trailing twelve-month interest expense of the Leverage 100 right now, expressed as a percentage of each company’s total debt, is 5.37%, and though that number was somewhat higher ten years ago (7.34%), interest expenses for public companies are in general a lot lower than what your broker charges.
Now some would argue that the reason these companies are getting such high returns is that they’re undervalued. In other words, the returns aren’t driven by leverage, they’re driven by investor mispricing. But I’m afraid that argument doesn’t hold water. The median EV/EBITDA of the Leverage 100 is 10.43; the median of the S&P 500 is 10.65. The difference is negligible, as is the difference in their median P/E ratios. It would indeed be hard to argue that Domino’s, Wingstop, Aspen Technologies, Weight Watchers, or Verisign are value stocks: by any conventional measure, they’re certainly not. Rather, they are companies that have figured out how to use massive amounts of leverage to their advantage.
John Rekenthaler, the vice president of research at Morningstar, has written that “purchasing securities on margin, at retail interest rates . . . is wiser than renting furniture with monthly payments—but only barely.” Instead, he recommends “investing in securities [that] put more than 100% of their assets to work.” That’s indeed the best way to get leverage to work for you.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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