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Shares are already leveraged

Discussion in 'Stock Market Nuts and Bolts' started by Zaxon, Jun 19, 2018.

  1. Zaxon

    Zaxon

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    Most companies have debt that they use to grow their business faster than if they had to save up the cash. So essentially, when you're buying shares, you're mostly buying an already leveraged asset. If you then take out a LOC or margin loan, you're leveraging and already leveraged asset.

    Does anyone else think about it from this point of view?
     
    explod likes this.
  2. galumay

    galumay learner

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    Yep. I never use leverage and I only buy part ownership of businesses with very low leverage. When the **** hits the fan, debt is the wrecking ball.
     
    explod likes this.
  3. Zaxon

    Zaxon

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    I feel the same way. The 1929 crash, the 2007/2008 GFC (and most other historical crashes) all stemmed from speculating with high amounts of leverage.
     
  4. So_Cynical

    So_Cynical The Contrarian Averager

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    I haven't looked at it that way but have to agree that it make sense, some of my favourite stocks have no debt, i personally have none.
     
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  5. Value Collector

    Value Collector

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    Debt is not necessarily about "growing faster", it can be used to raise the return on equity for the share holders (eg the owners of the equity), and provide low risk returns for others investors (debt holders).

    When the debt is supplied by longterm bonds etc, if can be a way of developing a capital structure that allows a capital intensive business to be funded by a wide arrange of people with different risk and reward profiles.

    For example,

    Say we need to build a big Wind Farm thats going to cost $200 Million dollars, and we need investors.

    Conservative forecasts might tell us the project will deliver a 9% return over the 30 year life of the asset, that specific return and risk profile only appeals to a specific sector of investors, but we can appeal to a much wider group if we structure the capital using a few different types of debt and equity.

    To provide the $200 Million, we could seek.

    $60 Million from Share holders
    $30 Million Bank debt @ 7% interest
    $50 million from Junior Bonds @ 5% interest
    $60 million from Senior Bonds @3.5% interest

    So over all we have our $200 Million and it will earn 9.5%

    But,

    Share Holders earns 20% If all goes well, but are the first to lose capital if it goes bad.
    Bank Debt earns 7% But have the share holders capital as a protection Buffer
    Junior Bond. earns 5% But Have share holders capital and Bank debt as a protection buffer
    Senior Bond earns 3.5% But won't lose anything until all the other investors have lost.

    Yes, you are.

    essentially you are doing what I described above on a personal level.

    You could take that shareholders position that you think will earn 20% if all goes well, and fund it with debt at 6%,

    So if you put in 30% of the funds and borrowed 70%, you will increase your return from the 20% per year to 52% per year (if all goes well).



    Nothing wrong with it, its just every time you bring in debt you are expanding your total possible return, but also your total possible loss, you have to be aware of that extra risk.

    Without debt the most you can lose is 100%, but with debt you can lose 300% of your money.

    You just have to think of debt as bringing in another investor, who is going to give any profits over a set interest rate to you, however for that they are using your capital to provided insurance on their position.
     
    luutzu likes this.
  6. luutzu

    luutzu

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    I always thought that lenders would also lose everything (in practical terms) if their debtors goes down the tube. So why lend when you'd only lend to the safe ones; and safe ones making higher return mean you ought to in on that boat that earn a higher return... practically the same risk anyway.

    But I guess it make sense what you're saying there. Those large managed funds can say that them lending as well as owning assets... a more balanced portfolio with different risk profile. A safer place to park the cash short term.
     
  7. Value Collector

    Value Collector

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    there is two ways the Debt holders have higher safety.

    1, debt holders have priority to Income -if the project ends up earning less than forecast, the company can cancel dividends for years giving no income to share holders, but still having enough income to pay the bond interest,

    2, In the case of liquidation or reorganisation - Shareholders will be the first to lose capital, the bond holders have first claim on any cash that comes from asset sales until all their capital and interest is repaid, the share holders can also be completely wiped out while the bond holders may have their debt transferred to the surviving entity after reorganisation.
     
  8. luutzu

    luutzu

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    Yea I guess at a certain level for a certain rate of return, debt is sensible.

    Though I find that no matter what the debt ratio says, often, when a company goes into administration, lenders would be lucky to get 10 cents on a dollar back.
     
  9. Value Collector

    Value Collector

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    It depends on the types of assets owned by the company, and the lenders should be factoring all that into their risk reward calculations.

    Use Real estate as an example.

    If you want to buy a house, the bank will lend you money, But they will want you to put up a "deposit" of 20% or so.

    Think of that "deposit", as your equity.

    If the house was worth $500K - you put in $100K of equity and the bank puts in $400K of debt.

    If the deal goes south and the house must be sold, you have to lose all your $100K equity before the bank begins to lose, Your equity is their protection.

    Its the same at companies, Share holders are "equity" holders, a share holders position can go to Zero while the bond holders are still are ok, any assets at the company will be sold or reorganised to the benefit of the bondholders until they receive 100% before any goes to the share holders.
     
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  10. galumay

    galumay learner

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    For all that, I still want to invest in unleveraged, or very low leverage businesses and I never use leverage myself. The short of it is my potential returns suffer somewhat, but my primary goal of protecting capital is fulfilled!
     
  11. Knobby22

    Knobby22 Mmmmmm 2nd breakfast

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    Then you can't invest in Transurban. A very good company that makes toll roads. I think it depends on how the debt is used and how much risk it creates. I generally prefer low or no debt except in infrastructure companies.
     
  12. Value Collector

    Value Collector

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    That’s totally understandable, some companies are suited to having debt as part of their capital structure though, even Warren Buffett who always talks about the danger of leverage is willing to use leverage in his energy utility and railroad businesses.

    Eg, companies holding stable long term assets that can sources cheap long term financing.

    But yeah some companies do not suit it at all.

    ————————

    There are cases where companies I own have done capital raisings to get money for projects, where I would have preferred them to use debt.

    It’s easier to get rid of debt holders than it is shareholders, so it can be better to use debt holders for a while than bring in more shareholders to dilute you.
     
  13. Zaxon

    Zaxon

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    The only thing I'll add to that is that Buffett lets the managers of his companies make their own decisions. So it's quite possible to find his wholly owned companies making decisions that he wouldn't do himself. Perhaps debt is an example of that.
     
  14. Value Collector

    Value Collector

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    No, He thinks debt in the large Infrastructure business is good, he has said it many times, Even Ben Graham (Warrens Mentor), Points out in both his books that large utilities are basically special cases when it comes to debt, due to the long terms and low interests available to them, and the regulated contracted income that generally raises with interest rates.

    He also threw around the Idea of $10 Billion of debt to finance Precision cast parts when he bought it for $35 Billion, even though he had ample cash, I am not sure if he went ahead with it.
     
  15. Value Collector

    Value Collector

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    Also, the financing that I broke down in my made up example of the wind farm, is pretty much how APA work, due to their financing strategy of using long term low rate bonds, Share holders equity is throwing off operating cashflow of about 24%.

    And where you have said you have been worried about them doing capital raising, those injections of capital have just been to provide more share holders equity, so they can do more projects on the same finance terms.

    eg, they raise $30 of equity so they can borrow $70 and then go and build another $100 of new infrastructure.
     
  16. Value Collector

    Value Collector

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    Take a look at APA, they have delivered total share holder returns of about 20% pa, for over 15 years.

    delivering a great mix of capital growth and dividends, in the 18 years I have held they have gone up in value by 500%, and currently deliver a 27% dividend based on my original entry price, a nice quiet achiever in my portfolio,
     
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  17. luutzu

    luutzu

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    Debt financing, like everything else, is reasonable and acceptable if the business does not depend on it to survive. So if the business is capital intensive but its income and cash streams are stable and predictable... and if it can borrow for at or below its rate of return etc., then of course it should use other people's cheap bargain.

    But that doesn't mean that if the business is a utility or large infrastructure that debt level doesn't really matter.

    But then seeing how APA is being pursued for the equivalent of some $23B enterprise value... I guess nowadays if you're big enough some idiot will take you over. Maybe they use a different calculus than just the financial ones... But depending on such gold knights shouldn't be a business model.
     
  18. luutzu

    luutzu

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    Na.

    APA is just a ponzi.

    I've studied BNSF... I reckon I can figured out a highly capital intensive business that's also doing well; to one that just raises equity to borrow more.

    Not saying that you didn't figure that out. Just that maybe your judgment is impaired seeing how you're among the earlier investors in that ponzi.

    I wouldn't complain either if I jumped in early.
     
  19. luutzu

    luutzu

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    Total shareholders return were calculated by APA as share price appreciation plus dividends, yes?

    In APA's case that measure is quite misleading.
     
  20. Value Collector

    Value Collector

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    Nope, Just a well managed and well financed company holding cash generating assets critical to the Australian economy.

    How is that misleading? Total share holder returns are a function of share price and dividends, are hey not?

    It's a pretty standard calculation, to show the performance of a company or index had you held the investment over a given time and reinvested all the dividends etc.

    Commsec calculates if for you for any company.
     
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