Investing (or Speculating?) in Leveraged Companies
If you've ever made 10 times your money on anything, you'll know that it releases a certain chemical in your body—and you want that chemical released again.
Proceed with caution. That may be the only sensible advice to anyone seeking to profit from investing in highly leveraged companies. Warns Tim McElvaine: “The single biggest mistake I've made is having companies that have too much leverage…”1 Adds Jake Rosser: “Whether it be AIG or Long-Term Capital Management, most of history's largest investment wipe-outs have been accompanied by leverage. Once you take on leverage, you no longer have control over your destiny. The use of leverage entails binary outcomes with a huge payday at one end and the permanent impairment of capital at the other end.”2
Investing in equity stubs may shake up your portfolio and your confidence. Nonetheless, money can be made in this portion of the public company universe. If selected properly, equity stubs can be one of the most rewarding pieces of a portfolio. Table 9.1 shows the effect of balance sheet leverage on the returns of an equity investor. In scenario 1, we assume that the market's estimate of enterprise value increases by 50 percent, and in scenario 2 we assume that enterprise value decreases by 20 percent. These changes in enterprise value have a disproportionately large effect on equity value if a company employs financial leverage.