Investors should never forget the two types of leverage: financial and operational

Writing for The Globe & Mail, Avner Mandelman produces an insightful article reminding investors about two types of leverage present in their portfolio. Leverage comes in two forms: operational leverage and financial leverage.

Financial Leverage

Financial leverage is the most obvious but most long-term-oriented investors avoid it. Put simply, financial leverage amounts to borrowing money from someone and investing it. If the investment does well, you make more money than you otherwise would have—you make money using other people's money. If it blows up, well, you end up with an even larger loss.

My impression is that financial leverage of portfolios—known as using margin—is more common with traders and other short-term investors. It is also commonly used by investors of exotic assets and derivatives. For long-term investing, it is not that common. Following what Warren Buffett has suggested, I personally do not use any leverage in my portfolio and probably never will.

It should be noted that the discussion here pertains to the financial leverage of a portfolio. You can have businesses using financial leverage themselves. That is, just like how you can borrow money for your portfolio investments, a business can also issue debt or take on bank loans to increase its financial leverage. In addition to your own portfolio financial leverage, you should factor in the financial leverage of the businesses you are investing in.

Net Exposure Not What It Seems

What if you balance your borrowing as with a long-short fund? Avner Mandelman goes on to detail how net exposure is not representive of actual risk (bolds are by me):

However, some managers (like those who e-mailed me) insist they can minimize margin risks if they balance longs with shorts. Say you have $10. You buy one stock for $8, then borrow another stock at $8 and sell it short. Your net long position is zero, but you are really 60-per-cent margined. And your market risk is still high, because what if both your picks are wrong? What if the long goes down and the short up? You could lose a lot in a hurry.

To make it worse, some hedge funds use even higher leverage, such as 130 per cent long/100 per cent short. Their pitch is: We are only 30 per cent net long and so should fluctuate less than the market while giving you higher returns. So, on a risk-adjusted basis you are better off. But is this true? Nope. Risk is not volatility. Such a fund's market exposure is 230 per cent, so if they are wrong on both longs and shorts, the portfolio can melt - as many such did last year. Further back, in 1997, Long-Term Capital Management went bust carrying high long/short leverage to a ridiculous extreme.

Which is why good hedge fund managers always look at two key ratios: long exposure (long minus short, divided by total assets); and market exposure (longs plus shorts, divided by total assets). The first ratio indicates how bullish (or bearish) they are. But the second ratio indicates how safety-conscious they are.

Shorting is not part of my portfolio strategy but it is something that is more riskier than it seems. As Mandelman points out, you could have net exposure of 30% but your worst-case exposure could be 230%! Although being long and short appears to balance the portfolio, you can get blown up pretty badly if you are wrong on both the longs and the shorts.

Some of the hedge fund portfolios I have looked at are short some stocks and long others but their risk is never clear to me. Two examples of investors who use substancial long and short positions are Hugh Hendry of Eclectica Asset Management and David Einhorn of Greenlight Capital. The net exposure for these long-short funds appears low (because shorts offset longs) but I have no idea what the ultimate risk is.

Operational Leverge

The other leverage that can be present is operational leverge. This is not something that that is within the control of the investor and is part of the business you are investing in.

Now for operational leverage: Unfortunately it is not one you can compute easily, yet it can decimate your portfolio just as quickly as financial leverage. In simple terms, operational leverage is the increase in a company's profit (and thus its stock price) due to increases in the price of a key product, or a commodity, or volume of sales. Obviously, it is closely related to cost structure. For example, say you are bullish on gold, and have a choice between two companies: one with low production costs, the other with high costs. The first makes money now. The second barely does. But if the price of gold rose 10 per cent, the first company would make 10 to 15 per cent more profit, the second's profit - starting from a low base - could double or more. Thus buying an operationally levered company is similar to buying a call option - here, a call on gold price. Of course, if gold prices fell, the second company's stock would plunge. Thus if you own stocks of operationally levered companies, your financial leverage may still be low (you haven't used up all your cash), but your portfolio's operational leverage would be high - it's as if you had filled your portfolio with call-option equivalents. Very risky.

Operationally leveraged companies tend to be in industries related to natural resources, manufacturing, and transportation—at least that's my impression. In such industries, fixed costs tend to be really high. If you wanted lower risk then you should look for companies with low operational leverage.

Unlike financial leverage, I notice a lot of long-term investors, especially value investors, invest in operationally leveraged companies. Many who invest in cyclicals such as an oil & gas E&P company or an airline attempt to capitalize on operational leverge. For these companies, a small change in sales will result in massive swings in profit.

Summary

Many proably already do this whether they realize it or not, but it pays to think about the leverage of the portfolio, as well as the leverage of the companies themselves. One should think about the financial leverage and the operational leverage inherent in their companies or their portfolio. Leverage isn't necessarily bad and can boost returns. However, one should never forget that leverage cuts both ways!