Leveraging Trouble

When Warren Buffett speaks, you should listen. I recently came across a Buffett quote that I think has eluded even the most sophisticated investors and reminded me of one of my favorite investing stories.

And I quote: "An irony of inflation-induced financial requirements is that the highly profitable companies -- generally the best credits -- require relatively little debt. But the laggards in profitability never can get enough."

Pioneering after the crash
In the late 1980s, a young undergraduate student named Ken Griffin toiled away in the Harvard Business School library, trying to figure out something that had puzzled him: As a result of the market crash of 1987, the prices between convertible bonds and the stocks they converted to didn't make sense. Apparently, beer pong and football weren't enough to keep this college freshman occupied, so he began writing his own computer software to rationalize the price of convertible bonds and exploit the difference.

In the summer after his freshman year, Griffin raised $265,000 from friends and family and formed a mock hedge fund from his dorm room, complete with a custom-made satellite service that gave him real-time market data. The returns were astronomical: Griffin's ingenious convertible-bond strategy returned 70%, 43%, and 40.7% in his first three years, respectively. In between becoming a financial prodigy, he also apparently managed to dominate the local sandlot soccer team.  

Griffin parlayed his early success into Chicago-based Citadel Group, one of today's largest and top-performing hedge funds. Citadel has ventured into other realms of investments that center on the shunned areas of the market -- such as its recent investments in battered mortgage company Accredited Home Lenders (Nasdaq: LEND  ) and coal-car manufacturer Freightcar America (Nasdaq: RAIL  ) -- and it has kept investor returns high even during market downturns. Returns have been rumored to be as high as 26% per year from 1990-2005.

Profits from Griffin's coveted convertible-bond arbitrage technique, however, began to slip as other investment managers caught on and plowed money into the seemingly guaranteed path to easy money. By 2003, the market for convertible bond arbitrage had become more bloated than Robert De Niro in the closing moments of Raging Bull. It became nearly impossible for hedge funds that employed this technique to keep their heads above water. Annual returns from convertible arbitrage averaged just 3% in 2004, less than some online money market accounts at the time.

Rather than acknowledge that the convertible-bond market was overblown and moving on to a more sensible strategy, some hedge funds turned to leverage (investing with borrowed money) to juice their shrinking returns. Can't make enticing returns anymore? No problem! Take your 3% gain, leverage up to your eyeballs and ... presto-change-o ... you're back in the money!

Or so they thought.

If you're so smart, why do you act so stupid?
Instead of staying competitive, leveraged convertible arbitrage funds became slaves to their creditors as returns continued to fall. They finally reached negative territory in 2005.  As Buffett pointed out, strategies with lackluster returns are the ones needing debt to stay in business. Those who insisted on leveraging a slim-profit game ended up losing control over what little edge they had, and they ended up turning a once lucrative investment strategy into no less than picking up pennies in front of a steamroller. The aftermath: Three multibillion-dollar convertible arbitrage hedge funds went kaput in early 2005 as creditors came knocking on their doors.

Hedge funds in 2005 seemed to fail to realize why Griffin achieved so much success with convertible arbitrage: The prices he paid were unjustifiably low, so his returns were subsequently high. As prices more accurately reflected underlying value in 2005, exploitation ceased and the debt needed to sustain returns eroded every bit of value that could be sucked out of the overly popular technique.

Foolish takeaway
Employing a sensible and rational strategy, such as Ken Griffin did in the late 1980s, can lead to outsized returns without the need for leverage. Any Fools thinking of investing on margin should think twice about leveraging their portfolio in hopes of stellar returns. What counts in investing is not how excessive you can get with a mediocre idea, but how well you can do with a fantastic idea. It's another example of how being in the right place, at the right time, and paying the right price, can be the most intelligent way to Foolish success.


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