April 27, 2015

Don’t Give In To the Siren Call of Leverage

So much misfortune in life can be sidestepped if you simply make it a rule to never stretch your finances, yet it’s a rule I see violated more than any other both through observation of those around me and through the messages I receive.  Someone can afford a $150,000 house but they try to buy a $250,000 house.  Another can realistically go to a college that will cause them to graduate with $10,000 in debt but they want to sign up for the program that will put them $40,000 in debt.  Then, not only do they have to hustle to try and meet their legally promised payments, they have to pay rent (in the form of interest expense) on the savings they’ve temporarily borrowed from someone else through an intermediary such as a bank.

Life is much easier when you don’t have this pressure.  Unfortunately, even smart people give into this temptation to overspend and gear up the leverage so you need to be vigilant against it.  Consider the case of the father of value investing himself, Benjamin Graham.  Since we talked about him the other day, it seems an appropriate case study.

In 1929, Benjamin was 35 years old.  He had started a small investment company, and augmented his income with writing for major publications.  Overseeing $2,500,000 in capital from friends, family, and other clients, Graham had used these funds to purchase $2,500,000 worth of hedged positions as well as $4,500,000 in margined long-term stock positions, bringing his total balance sheet to $7,000,0001.  To provide some historical context, if we adjust these figures for inflation, Graham was sitting on $34,200,000 in capital belonging to his stockholders, and he had leveraged this up to $95,755,000, part of which was hedged.

This provided him a very high standard of living.  In the past, I’ve laid out the compensation structure of the Graham Newman Corporation, which gave Ben and his partner high base salaries plus significant cuts of the profits.  With a household income that surpassed the wildest imaginings of the typical American during this time, he gave into the hedonism of the day and was living extravagantly, leasing one of the most expensive apartments in New York and employing a cadre of servants.  It’s hard to fault him too much considering only a couple of decades prior, he had been left destitute when his father died unexpectedly.  The boy Graham had entered the workforce as a teenager and supported his widowed mother.  The siren call of a gilt-edged life was too much for him to resist.

Ben Graham Security Analysis LeverageAs stock prices began to accelerate during the latter half of the 1920’s, Graham was writing about the overvaluation with increasing concern.  He believed that the holdings in the Graham Newman portfolio were cheap enough based on underlying intrinsic value that they should survive any downturn, failing to foresee the forced liquidations that would cause even cheap companies to trade at less than the cash balances they held in the bank.  Combined with the leverage he allowed himself to take on when times were good, and the improbable misfortune of living during the worst economic collapse in 600 years, he faced a near catastrophic decline in the quoted value of his holdings.  By 1932, his business had lost 70% of its net worth.

In his memoirs, Ben reflects on this period by saying, “I blamed myself not so much for my failure to protect myself against the disaster I had been predicting, as for having slipped into an extravagant way of life which I hadn’t the temperament or capacity to enjoy.  I quickly convinced myself that the true key to material happiness lay in a modest standard of living which could be achieved with little difficulty under almost all economic conditions.”  As James Grant wisely puts it in his opening text of the recent reprint of Security Analysis, this was Graham applying the margin-of-safety concept to his own personal finances.  Graham had learned The Micawber Principle.

Sometimes Misfortune Can Lead to Great Triumph

Fortunately for all of us, Graham’s folly led to his greatest triumph.  It was with this backdrop, and having suffered these declines, Graham set out to find an investment philosophy that would allow someone to prosper, or at least mitigate risk, in all fiscal environments.  While he focused on some technical operations that are simply not possible today (net working capital stocks bought on a widely diversified basis are long gone, unlikely to return until the next Great Depression), the general thought process ended up spawning multiple billionaires, countless multi-millionaires, and saving a lot of emotional turmoil.  He striped the emotion and excitement out of investing and made it all about the cold, hard cash.  He greatly improved the discipline of financial analysts and turned it into a legitimate profession.

Having learned from experience, Graham spent the rest of his life living much more modestly relative to his means.  Given his investment acumen, he was still absurdly rich compared to the typical American, retiring to the oceanside enclave of La Jolla, California and spending half the year in France, yet he had none of the financial pressures that accompany so many families.  (On a side note, Graham’s French escapades are worthy of their own post given the lessons that can be drawn from his moral failures.  He had an affair with his son’s French mistress after the son committed suicide, leaving his long-time wife in their older years to be with the other woman after the wife, quite rightly, refused to spend half her year in France with him as he went around sleeping with another woman.  Doing case studies of his life, it’s hard to reconcile the kind man so many people think of fondly with the husband who treated his wife so cruelly.)

Personally, my rule has been that even in a Great Depression, you should be able to maintain your standard of living without losing a single moment of sleep.  Others apply different rules.  Bill Gates was famous for keeping 12 months of cash on hand so he could pay all of his bills for an entire year even if revenue went to nothing overnight.  Suze Orman thinks the average family should keep eight months’ worth of cash on hand as an emergency backstop.  In his recent shareholder letter, Warren Buffett mentioned that one of his bequests will involve setting aside 10% of the principal for cash equivalents.  The specifics will depend on your unique circumstances, but you have to be prepared for when things go south.  They have, they will, and that’s just life.  Any system or estate that isn’t built to withstand that adversity is poorly designed or improperly managed so get to work if you aren’t in that position today.  It’s even more important than funding your investments.

What if you screw up and find yourself in a position that requires fixing?  Forgive yourself, fix the problem, and move on.  If a brilliant mind like Ben Graham can fall prey to cheap money and easy sex, accept you are only human and vow to avoid repeating the mistake.  Some of history’s biggest fortunes were made by those who were wiped out entirely.  It’s not the end of the world, even if it feels like it.

1 Benjamin Graham and Security Analysis: The Historical Backdrop by James Grant, Introduction to the Sixth Edition of Security Analysis, 2009

  • DividendGrowth

    Leverage could bring a lot of money fast, but could also result in quick losses. An investor who puts money away every month in quality dividend paying stocks selling for attractive valuations will get rich one day. They do not need leverage to get rich, yet many decide they can’t afford to wait. By trying to get rich in a hurry, they end up undoing the positive effects of their hard work.

    However, I would be interested in a product that would allow me to buy stocks with the terms of say a 30 year mortgage. I get a $100,000 loan payable in 30 years, which I can use to buy stocks through my bank only. I would then pay monthly payments, and would not have my securities repossessed if they fall in value. Stocks are portions of businesses, which are assets just like houses. So I wonder why noone has done this. I am sure people would be interested in this product.

    • http://dividendgamer.com/ Scott Holland

      This is where people can be tempted to invest with student loans, or a similarly structured financial loan package.

      I have yet to utilize any form of leverage in my own life, and I think it should be avoided if it can cause a high degree chance of wipe-out risk.

      With a secure and dependable source of income, it can be a useful tool, but I would keep it under 20%.

    • peter gryphon

      At least one issue I see with that type of leverage is that you’d have a 100k to put into the market all at once, which is inherently risky for the vast majority of investors. If one could theoretically qualify for a low interest rate 100k loan from a bank, then they could probably afford to put at least 10k a year into a tax sheltered account, with the added benefit of dollar cost averaging. If you started at 24 years old, then you’d have your 100k by age 33 (assuming an 8% return), and have 32 years for that 100k to compound until retirement at 65. Easy…peazy…japaneasy.

      • DividendGrowth

        I do want to question the thinking that it is “socially ok”
        to take a loan of $100,000 and buy a house “all at once” to pay off for 30
        years, but it Is not socially acceptable to take a 30 year fixed loan of $100K and put that $100,000 in shares of quality businesses that are fairly or attractively priced and will pay you for decades with rising dividends. A house is an asset just like a business, so that’s why I don’t think taking a loan on either is any different in reality.

        Well, in reality I am putting a set amount of money every
        month to work in dividend paying stocks. So in effect I am striving towards
        paying off that imaginary $100K debt. However that debt is mostly to my future self, who will be living off the labor of my current younger self 😉

        However I do not mind putting the whole $100K in the market
        all at once. I would take this amount in quality dividend paying stocks, with
        prospects for future growth, and that sell at attractive valuations. Obviously you should be selective on what you buy, and at what price you buy it. Even in today’s environment, there are quality companies selling at fairly good prices for someone who will hold them for 30 years. I don’t think anyone can time their entries perfectly, but with a 25 – 30 year horizon it won’t matter as much if you bought at the high or the low for a given bear market.

        In terms of actual leverage, I use margin sometimes to buy a stock to take advantage of an opportunity to buy something that is temporarily depressed, but I won’t have the actual cash for 1- 2 weeks. I then pay it off with cash I put to work or from dividends I receive. I do that a few times a year because broker leverage is expensive, and rates fluctuate – I want fixed rates for long periods of time.

        • Eric

          You keep saying “quality companies”, but doesn’t every company think they are a quality company? 8 out of 10 quality companies fail within 18 months, and Senator Rand Paul just made the claim that 9 out of 10 businesses fail. The Bureau of Labor Statistics says half (50%) of established businesses fail within the first 5 years. If you take Jeremy Siegel’s advice and only buy companies that have survived the test of time, you run the risk of limited growth and limited upside. Investing in stocks is not as easy as it may seem at the moment. If you are right in your claim that you know which companies are sure bets, 1. a bank won’t believe you, and 2. you will do well regardless of if you have leverage.

    • poor.ass.millionaire

      While this is an interesting idea, in reality this will never happen. Why? 30 year fixed rate loans are backed by the US Gov big time. No private bank or enterprise in their right mind would loan out for 30 years, much less at a low fixed rate! The US Gov backs these loans because: A- it has huge reserves. B- controls the central bank (kinda easy to manipulate monetary policy that way). C- believes that home ownership is a cornerstone of the American experience, enhancing quality of life, community stability, etc. And furthermore, the debt is secured by a hard asset (normally solid, but last bubble period/ninja loans tested that hypothesis.) I doubt the US Gov views investing in stocks with borrowed money in the same light.

    • A Patel

      I was thinking the same idea a few months ago. I would suggest a product where an individual would purchase a set amount of stock, let’s say $100K of KO. The individual would make payments on a monthly basis to the lending entity (likely a bank) for a term of something like 15 years, after paying a 20% down against this asset. So essentially a 15 year ammortized loan of $80K for the access to purchase 100K KO stock today. The bank would hold the stock as collateral, but the dividends would still get posted to me. This would protect the bank against the chance that I could sell the asset prematurely without them being aware of it. I would be unable to sell the stock because the bank would be holding the stock certificate as collateral. For an adept bank, this seems like a reasonable plan to generate loan income from an appropriate customer. I would assume that for a young professional with decent Income but starting in their early 30’s due to the time spent in grad school, this would be a desirable product.

  • Frederick

    “Most of the world’s ills are caused by liquor and leverage.” -Charlie Munger

  • innerscorecard

    Great post. I wonder if you can write more about educational leverage as well. I think the old chestnuts of wisdom espoused by Thomas Stanley and the like that some of the only good debt is student loan debt are not true anymore. It can be good, but is often some of the worst debt you can have. Sure, you can use IBR and PAYE to have it go away after 25 years, but you are mentally dooming yourself to low income for decades – as you are punished by interest if you happen to have a higher income somehow – for that to happen.

    Look at the market for lawyers. Student loans for law school used to be a non-brainer. Now there are literally only jobs for 50% of newly admitted lawyers. And this is a profession where to be a good lawyer you need to learn under an established system. You can’t just tell all young lawyers to start a new firm – most would be committing malpractice.

    Even students from top 14 law schools are jobless – it’s masked for those schools, though, as many of them give “fellowship” or “RA” positions to unemployed graduates at $15 an hour to increase their unemployment statistics.

  • Breathaholic

    Great post Joshua.I read his autobiography few years back, The Memoirs Dean of Wall Street. Then I remember WB said that nobody really got too close to Ben, beyond his shell that is. That story about an affair with dead son’s ex was hard to understand, I still don’t. I didn’t see it coming, intellectually I couldn’t quite explain it and at the emotional level I was disgusted. Not a poster child for loyalty lessons in life, but margin of safety and Mr. Market analogy are just amazingly useful and simplifying ideas of complex human interaction. I took what I liked and worked for me:)
    Kipling claimed Homer did the same (not the Simpson, the other guy:))
    Little poetry for those so inclined.

    When ‘Omer smote ‘is bloomin’ lyre,
    He’d ‘eard men sing by land an’ sea;
    An’ what he thought ‘e might require,
    ‘E went an’ took—the same as me!

  • mikecrosby

    I think the time to leverage or take big chances is when starting out in business. Since assets are small, net worth is small, the upside can be high while the downside not so much.

    Warren B. idolizes Mr Graham. It was nice to get a more complete picture of the man.

  • Scott

    Leverage is a tool, which used appropriately, to buy appreciating assets has created vast amounts of wealth. Many businesses would not have gotten started without the infusion of debt financing. I wouldn’t advocate flagrant spending in ones personal life, but lets be careful of throwing the baby out with the bath water.

  • Eric

    I concede that if you are buying large cap, dividend paying stocks that have survived the generation that founded them, you will do quite well. But I still maintain that the explosive growth is behind most of those companies. I think it’s why Berkshire loves their Coke returns, but they haven’t invested in KO since Coke’s worldwide expansion in the 1990’s.

    And while you, me, and Jeremy Siegel may agree on what a “quality company” is, your situation where banks give home-sized loans to invest in the stock market means those loans will go to people who will have very poor results, because they will invest in things like new tech companies with a gnats lifespan.

  • fran

    I read in December an article in the WSJ regarding how Buffett’s investing model has always included buying stocks on margin. I could never consider this for myself. It must require extreme self-confidence in your investments, which would seem odd for a fully informed person that knows any investment could go to half at any time. I am perplexed.

  • FratMan

    I’ve been hearing a siren call to build up a supersized position in Coca-Cola using some leverage. With this post and a cold shower, I should be in the clear.