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Thursday, 11 June 2009

Debt Matters

Borrow Wisely

If anyone was in any doubt about how much debt matters to individual stockmarket investors and their preferred investments, the events of the last few years should surely have convinced them otherwise. Debt is one of the most critical factors investors need to consider in making their investments, and it’s not just a matter of the corporate borrowings of companies but also of personal loans – from mortgages through to credit card payments.

The problem is that when times get tough for companies, and they have trouble refinancing their borrowings, this generally foreshadows private investors having the same difficulties. Get this wrong and you find yourself with increasing debt, decreasing income, sliding investments, relationship difficulties and under extreme psychological pressure to do exactly the wrong thing. None us should be in any doubt – debt matters.

Corporate Debt Daggers

There was, for a while, a theory that loading companies up with debt was a good constraining factor on managements. Oddly enough this theory was mainly propounded by the people extracting the cash from the companies so they could go buy yachts and private islands to berth them on. As usual Warren Buffett punctured this argument rather neatly:
"The analogy has been made (and there’s just enough truth to it to get you in trouble) that in buying some company with enormous amounts of debt, that it’s somewhat like driving a car down the road and placing a dagger on the steering wheel pointed at your heart. If you do that, you will be a better driver – that I can assure you. You will drive with unusual care. You also, someday, will hit a small pothole, or a piece of ice, and you will end up gasping. You will have fewer accidents, but when they come along, they’ll be fatal. Essentially, that’s what some of corporate America did in the last 10 years. And it was motivated by huge fees. And it was motivated by greed."

Unfortunately the long and winding investment road is liberally strewn with potholes you can only see with hindsight, populated by madly overconfident executive drivers and punctuated with tempting shortcuts that turn into rough, bumpy dead-ends. Any company so constrained by debt that these common events can lead to their death isn’t one investors should be dabbling in.

Corporate Debt Traps

Most companies need some debt to fund ongoing operations, for working capital and so-forth. It’s a rare company that can cope with really significant debt over the entire economic cycle because what’s repayable during the best of times may not be covered during the worst. Apart from those very unusual corporations that can pretty well guarantee constantly growing cashflow regardless of the economy most organisations should limit their debt to that which they can cover comfortably near the bottom of the market.

Sometimes it’s not even the fault of the company that debt leads to problems. The paralysis of lenders over recent times has meant the ability of companies to refinance their fixed-term loans has been very constrained. Being in the unfortunate position of needing to replace borrowings during 2008 led to a whole range of companies’ valuations being hammered. Mostly corporations with decent business models and sustainable cashflow have survived but for some it was a near run thing.

When this happens, companies need the ability to refinance through equity markets, by issuing more shares. It’s best to do this from a position of financial health rather than from the sickbed. What’s true of companies is doubly true for private investors.

Personal Debt and Stock Investments

Private investors really shouldn’t have personal debt while investing in the stockmarket. With, at best, an average annual return of 12% it really makes no sense to be paying double digit interest on hire purchase or credit card bills while putting money into stocks. It’s crazy and illogical behaviour – so, of course, there are plenty of people who do it.

The only type of debt it makes sense to run while investing in stocks is a lower interest mortgage. Buying a house isn’t something you can do in a couple of years and if you’re going to invest in stocks for the length of time it takes to have certainty of making money you’ve really got no choice but to take the risk that mortgage interest payments may outstrip your stockmarket returns during some of that time. Over the term of most mortgages it’s a certainty that this’ll be the case at some point.

The Psychology Of Gearing And Partner Pressure

Often, people who have a mortgage and invest in stocks find that they make more money on their house than they do on their shares. The main reason for this is gearing – if you borrow $90,000 to buy a house on a $10,000 deposit and the house goes to $200,000 you’ve just multiplied your investment by a factor of 10. Unfortunately if the house drops to $70,000 then you’ve lost 30% - this is gearing, the effect of borrowing to invest.

Most private investors wouldn’t borrow $90,000 to invest in shares but technically this is no different from the situation with property. It’s just that the risk is not so apparent with houses because nearly everyone has to do it. However, the psychological problem of managing a massive loss of capital on the stockmarket is often more difficult to handle: the valuations of stocks are visible every day, unlike house prices. Investors’ partners can see them as well – you can tell there’s a front-page crash going on when the non-investing significant other starts asking about portfolio valuations. That’s real pressure.

As long as the companies in question are well managed then the best bet is to ride out the storm but time and again we see small investors panicking near the bottom and selling. If you’re investing using borrowed money you need to be darn sure you can survive such moments financially – and mentally.

Don’t Go Under When It All Goes South

Not investing in stocks at risk from debt problems using money you haven’t got ought to be a no-brainer. However, there’s another, more intractable issue: you’re invested in the stockmarket for the long term when it goes haywire and even decent companies suddenly start to struggle due to the unavailability of debt. As a long-term investor you know that, eventually, normality will reassert itself and that the massive loss of value you’ve suffered on your stock investments will turn out to be temporary.

Unfortunately the stockmarket downturn coincides, as it often does, with a downturn in the real economy. You, the sensible investor, face the double whammy of a huge reduction in your portfolio valuation and the loss of your job – and, of course, you have mortgage debt to service. Realistically we can’t plan for every eventuality, but making sure you have some short-term cash to hand is about as good as it gets.

The perfect investor, then, has a mortgage, a stock portfolio and cash in the bank: lucky them. In fact, the perfect investor should have some investments uncorrelated to the stockmarket as well, if you can find them: government bonds and a little gold would be high up my list. In a perfect storm it helps to have a submarine to hand.

Dealing with Debt

Investing for the worst case isn’t a sensible approach, because you may spend decades waiting for it, but assuming that good conditions will continue forever isn’t sensible either. Managing debt is a significant part of this process. It’s hard enough holding on to stocks when they go through one of their periodic loop-de-loops on the stockmarket rollercoaster but it’s far harder when you’re faced with trying to repay personal loans and wondering where your next pay check is coming from.

Time is the key for most of these issues. The critical thing is to avoid being a forced seller at the bottom of the market, even if you lose your job. There is nothing as psychologically soul-destroying as watching your stocks’ value being eroded day by day as markets fall – apart from watching them gain day by day after you’ve sold them.

Don’t let it happen to you; that’s why debt matters.

Related Articles: Gold!, Auntie, Why are my Bonds Bubbling?, Correlation is not Causality (and is often Spurious)

1 comment:

  1. Wouldn't a 30% drawdown on your house's value with only 10% equity investment result in a 100% loss and an underwater mortgage loan (rather than a 30% loss as you point out)?