Leverage. It's a fancy word for borrowing money. It's what many companies (and investors!) employ, to various degrees. If a company needs money, it might sell some stock, or it might issue some bonds. Similarly, we small investors are often able to invest "on margin," by borrowing money from our brokerage.
In both cases, this leverage is attractive because it can help us make more money, as we're investing more money. But leverage cuts both ways -- losses, as well as gains, get amplified with leverage.
If a company uses a lot of leverage (perhaps evidenced by a high debt-to-equity rating), it may be creating extra value for its shareholders, but it's also at risk. Because if its investments go south or are otherwise unproductive, it will still need to pay back what it borrowed.
The bottom line is that sometimes using leverage is smart, and sometimes it isn't. Most shareholders generally trust company CEOs to make the right decisions on how much leverage to use. But a recent study may make you think twice about that.
Recent research from professors at Ohio State University and Claremont-McKenna College looked at how CEOs handle their personal finances and found "a strong and robust positive relation between personal and corporate leverage."
In other words, they found that CEOs with significant personal leverage -- in the form of a hefty mortgage -- tend to oversee companies with higher-than-average corporate leverage. And the link is even stronger with CEOs and companies that have weak corporate governance structures in place.
The CEO isn't always right
What does this mean for us? Well, it drives home how influential a company's CEO can be. If she is a daredevil with her personal finances, she's likely to be a daredevil with the company in which you've invested your hard-earned dollars.
Also, it's a good reminder about watching out for the financial condition of the companies you invest in. I don't always get a chance to dig into what size mortgage my CEOs have, but I do remain wary of companies with high debt-to-equity ratios. For example, these large-cap companies popped up on my radar screen recently:
|
Company |
Recent Long-Term Debt-to-Equity |
|---|---|
|
Las Vegas Sands |
2.20 |
|
H&R Block |
2.38 |
|
Heinz |
2.92 |
|
Kellogg |
2.51 |
|
International Paper |
2.65 |
|
Deere |
2.53 |
|
Caterpillar |
3.76 |
Data: Capital IQ, a division of Standard and Poor's.
Should you avoid these companies? Not necessarily. You also have to figure out whether a company's debt levels are high enough to threaten its ability to make timely interest payments -- especially if its income shrinks. Knowing more about how your company's debt is structured is essential and valuable. (Many times you'll find the interest rates on corporate borrowings in the footnotes of an annual report or other filing.)
Clues at the top
This lesson also reminds me of how useful it can be to spend some time trying to get a feel for a CEO's character. Read some of your CEO's letters to shareholders, looking for candor and whether company executives take responsibility for disappointments. You might also look at compensation and perks. If they seem excessive, that can serve as a red flag.
Given how important corporate executives are to a company's success, it makes sense to spend some time looking at them. While a good CEO can make a good business great, a bad CEO can turn a great business into a terrible one.
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