Leverage

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'. It describes the amount of money a company borrows relative to its size. If a company borrows a lot it is said to be 'highly leveraged'. If it borrows not much it is said to be 'lowly leveraged'. If it has surplus cash it is said to be 'unleveraged'

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 because you've paid 5% for your money and put it to work (invested it) at 10%.

And if the shares had gone down 10% instead of up? Exactly - you've lost £500 in capital and paid £200 interest, total loss of £700 or 70%.

That's the principle. Here are just some of the many ways in which leverage crops up:

Corporate leverage

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.

Operational leverage

The company could sell its factory to a finance company, lease it back again and use the cash for other things. It has introduced a higher level of fixed costs into the business (the lease) 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.

Fund leverage

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.

Options

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.

Personal leverage

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......

Using leverage 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.