|Unless you know the leverage behind
your investment, you do not know what you have got.
In finance, 'gearing' and 'leverage' mean the
same. We'll use the American 'leverage'.
Don't think that leverage is an obscure financial
concept that can be ignored by the everyday investor. Quite the
reverse. It is fundamental to understanding the manipulation of
financial risk. It crops up within individual business operations,
in corporate financing, in investment trusts, in the construction
of financial products to sell to the public, in the trading of options,
in the trading of commodities and by directors and managers pursuing
their own 'incentivising' targets.
Leverage is a way of changing small gains (or
losses) into large gains (or losses).
What does it mean?
First, think what "leverage" means in everyday
English. You use a lever to change a small force and a big movement
into a large force and a small movement.
And it also works in reverse at the other end
of the lever. A large force and a small movement creates a big movement
(but little force) at the other end.
And that's what financial leverage does. It
magnifies the effect of small changes. If a change is good, leverage
will change it into very good. But if a change is bad, leverage
will change it into very bad.
Here is one example
Suppose you have £1,000 to invest, and you buy
£1,000 of shares. After a year they have gone up 10% and you sell.
You've made £100, or 10%.
Now suppose at the start of the year your granny
had lent you £4,000 at zero interest. You could then have bought
£5,000 of shares instead of £1,000. These would have turned
into £5,500 after a year. You would be left with £1,500 after repaying
your granny. A gain of £500 on your original stake of £1,000, or
50%. That's leverage.
.....and without Granny?
Now, you may be thinking you don't have this
sort of granny. But assume, more realistically, that you have to
borrow the money at 5%. Work through the sums and you'll find that
you would have still made £300, or 30%.
That's the principle. Here are just some of the
many ways in which leverage crops up:
Take an ordinary manufacturing business, Widgets
plc. It's financed entirely by shareholders' money. This is an investment
with a certain expected payoff and risk profile and will be valued
by its shareholders accordingly.
Now, suppose the company had instead chosen
to finance itself 50% from banks and 50% from shareholders. The
company is now said to be 'leveraged'. The shareholders, still nominally
holding an investment in Widgets plc, will nevertheless have a higher
risk investment than the one they had originally.
The company could sell its factory to a finance
company, lease it back again and distribute the proceeds to shareholders.
It has introduced a higher level of fixed costs into the business
(the rent) in exchange for releasing capital. This will decrease
its chances of withstanding a business downturn (because it will
move into loss more quickly).
This is called 'operational leverage' (or 'fixed
charge cover'). The shareholder still owns a widget manufacturing
business, but the risk profile has changed.
Widgets plc could be in the portfolio of an investment
trust. That trust could partly finance itself with borrowed money
- the trust would itself be leveraged. Effectively, Widgets plc
would then be doubly leveraged.
Or, you could buy an option to buy Widget shares.
If Widget was at 200p, you might buy options to buy at 195p for
around 5p (the price difference), plus a bit for charges and so
on. That way you could buy 20,000 call options of Widget for your
£1,000. And if Widget goes up 10%, or 20p, you'd sell at a 25p profit,
or £5,000. 500%! Now that's leverage!
Of course if Widget goes down 2.5%, or 5p, to 195p
your option becomes worthless. Nobody will pay for an option to
do something they can do in the market for nothing. So you've lost
all your money. That's leverage also!
See where we have got to here. There's no actual borrowing
involved. Just a financial instrument that has magnified the effect
of price movements. If you allow your money to be invested without
restriction, this is what you may get into.
You've met this. This is Granny above. It's also
almost certainly you, if you have a mortgage or any other debts
or even, arguably, if you rent your home.
So hang on to this idea......
You can take a nice stodgy investment and turn
it into something much hairier. This idea has made some people a
lot of money. But not the average investor.