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Wall Street's Biggest Secret -- Revealed!

By Chuck Saletta - Updated Nov 11, 2016 at 4:44PM

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And it has nothing to do with superior investing skills.

Warren Buffett famously wrote that "you only find out who is swimming naked when the tide goes out." As the 2008 financial meltdown showed us, pretty much all of Wall Street was out there skinny-dipping. As it turned out, the secret weapon behind their financial empires wasn't so secret after all: It was nothing more than leverage.

In a nutshell, they had gorged themselves on debt and used that debt to magnify their apparent returns. When they were making money hand over fist, it seemed like a brilliant way to run their businesses. But when the market turned against them, it was deadly.

Leverage cuts both ways
It's because of excessive leverage among investment banks that a few subprime borrowers failing to pay their mortgages morphed into a global financial catastrophe. This chart, which compares the differing returns on equity for given investment returns and leverage ratios, shows why:

Leverage
Ratio

1% Loss

No Change

3% Gain

4% Gain

0 to 1

(1%)

0%

3%

4%

1 to 1

(4%)

(2%)

4%

6%

4 to 1

(13%)

(8%)

7%

12%

12 to 1

(37%)

(24%)

15%

28%

25 to 1

(76%)

(50%)

28%

54%

35 to 1

(106%)

(70%)

38%

74%

Assumes 2% interest cost on borrowed money.

Just prior to its collapse, Bear Stearns was leveraged 35 to 1. At that insane level, it's pretty obvious how even some small losses could have wiped out everything.

The thing that made leverage so seductive to the investment banks, though, is what you can see on the right-hand side of that table. Even a small gain can be magnified, many times over, to turn a modest return on investment into a substantial return on equity. And at the end of the day, it was the return on equity that paid the investment bankers' obscene bonuses.

Who cares about value?
With those perverse incentives, it starts to get pretty obvious why we've floated from bubble (tech stocks) to bubble (housing) to bubble (commodities) over the past decade. When even small real gains can be translated into gargantuan paydays through leverage, what an asset is really worth matters far less than what direction it is moving.

Thanks to that effect, investment bankers were willing to pay too much for assets because they could leverage their way to tremendous personal gains. That was a neat trick while it worked. When the credit bubble itself burst, however, it forced them to unwind the bets they had made with all that cheap leveraged cash.

Your opportunity is knocking
As these giants are forced to sell anything they can in order to deleverage themselves, the same factors that had driven prices up are now working in reverse. The big difference is that these days, they don't care about value because they need the cash right now in order to stay afloat.

In the wake of their massive forced sales, you can find companies trading below:

  • Their tangible book values (an estimate of what their cash and physical assets are worth),
  • 10 times their recent earnings, and
  • 10 times next year's estimated earnings.

This table shows just a few:

Company

Price-to-Tangible Book Value

Normalized Trailing P/E Ratio

Forward P/E Ratio

Loews (NYSE:L)

0.74

5.4

5.5

Valero (NYSE:VLO)

0.69

4.8

5.8

Royal Caribbean (NYSE:RCL)

0.43

7.0

5.1

Southern Union (NYSE:SUG)

0.73

7.3

6.6

Marathon Oil (NYSE:MRO)

0.94

3.8

6.1

Bunge (NYSE:BG)

0.84

4.2

5.7

Chesapeake Energy (NYSE:CHK)

0.56

4.1

5.5

Data from Capital IQ, a division of Standard and Poor's.

When valuations start to look that attractive, does it really matter if the massive deleveraging has ended or if there's still some left to go? As long as you are not subject to the ticking time bomb of leverage yourself, you can seize this opportunity to profit from those bankers' forced selling by picking up shares in undervalued companies.

Are you ready to pounce?
While none of us like to see so much red in our portfolios, at Motley Fool Inside Value, we're absolutely thrilled that Wall Street's leveraged collapse has left us so many tremendous bargains in its wake.

It's not very often that Wall Street hands us such a great opportunity, but it's during times like these that patient investors can make a fortune. If you'd like some help choosing which stocks to buy, you can check out all of our top picks by joining Inside Value free for 30 days.

Click here to learn more.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta did not own shares of any company mentioned in this article, though his wife owned shares of Valero. Chesapeake Energy is an Inside Value selection. Royal Caribbean is a former Motley Fool Stock Advisor selection. The Fool has a disclosure policy.

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Stocks Mentioned

Royal Caribbean Cruises Ltd. Stock Quote
Royal Caribbean Cruises Ltd.
RCL
$42.06 (-4.58%) $-2.02
Loews Corporation Stock Quote
Loews Corporation
L
$58.78 (-0.03%) $0.02
Chesapeake Energy Corporation Stock Quote
Chesapeake Energy Corporation
CHKA.Q
Marathon Oil Corporation Stock Quote
Marathon Oil Corporation
MRO
$23.32 (1.15%) $0.27
Valero Energy Corporation Stock Quote
Valero Energy Corporation
VLO
$117.58 (3.77%) $4.27
Bunge Limited Stock Quote
Bunge Limited
BG
$100.10 (0.58%) $0.58

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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