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For me, working in the financial industry and being a business leader often presents some interesting challenges that are, at times, polar opposites. Two areas that really disturb me relate to the use of leverage, and the way diversification is promoted. What we are taught as business leaders is sometimes completely different to what we are encouraged to do as an investor. For example, in business we are taught not to diversify too much but I find that investors often end up being over-diversified. In both cases, the overuse of these areas creates real issues for investors.
One of the major principles in business is that cash flow is king, and this is certainly also true for investors. The premise of this principle is based on risk, or in other words, the ability to manage the “what-if” situation.
The “what if a major competitor moved in next door”, or “what if we if we have a downturn in the economy”, is what goes through the minds of business leaders all the time. We produce cash flow projections, budgets, and strategic plans from which to plan for and/or mitigate our business risk so that the business survives long-term. With investors the situation is similar, in that the “what if” comes in terms of the market or specific investment and the risk of that investment going south.
The conflict: Cash is king versus mitigating risk
In business, we look at return on investment, debt to equity and many other important ratios. When looking to borrow funds or leverage so that we can effectively run and expand our businesses, the banks take these figures and work out how much we can borrow.
The interesting thing is that if a business is running at a debt to equity ratio of 50% or higher, it is considered high-risk. As a share market expert and analyst, the level of debt a company holds will have a big influence on whether or not a stock is recommended. But what is really interesting is how investors are regularly encouraged to over-leverage and take on loans with debt-to-equity ratios of 70% to 90%, and it is not uncommon to see not just investors, but ordinary households, with 50%-plus of their income flowing out to fund debt.
The result of this over-leverage is that many, if not the majority of households, are cash flow poor, and in this situation their level of risk becomes extremely high.
During the GFC we saw mass selling of assets by investors unable to fund their high level of debt as their assets were falling in price – Storm Financial customers being one example. Right now we are seeing investors and households pushed to the limit in finding cash flow to finance debt and this has resulted in many selling their properties, shares and other assets to survive.
This brings me to some words of wisdom that I learnt at a very young age: to always leave something on the table for the “what-if”. In other words, never take 100% of what the banks will allow you to borrow. This thinking applies to any business as well as individual investors because: you never know what might be happen next, and you will have spare capacity to borrow to get you over a hump if need be.
History shows that the most money is always made by those who prepare for the inevitable boom following a correction. Right now cashed-up businesses and investors should be planning to take advantage of the opportunities to buy good businesses and or assets for income and growth. It is easy to see that this is already happening in many industries, as there has been an increase in takeovers and consolidations occurring.
For anyone with debt at manageable levels I can see big profits ahead from in the next boom. I think Warren Buffett says it best: “Buy in doom and sell in boom.”
In my next article I will investigate the myth of diversification and why it can be bad for your investments.