In golf, a hole-in-one is a remarkable achievement. The probabilities? About one in 850,000 from a distance of 150 meters – practically a statistical anomaly. Still, the LPGA Tour recorded 20 such incidents in 2023. How can that be? Quite simply: a low probability doesn’t necessarily mean a low frequency. Hold this thought for a moment.
Now let’s switch gears. Imagine two coin toss games. In the primary case, the coin is fair and offers an equal likelihood of winning or losing. In the second case, the coin is flawed: there’s a 60 percent likelihood of losing and only a 40 percent likelihood of winning. However, each games offer an expected return of 25%.
At first glance, most would argue that the faulty coin poses the next risk. But give it some thought rigorously. Both games are equally dangerous if we do not know the consequence upfront – especially if we only play once. The next strike could easily defy the chances. Therefore, risk will not be nearly the possibilities of winning. It’s in regards to the severity of loss when something goes incorrect.
Let’s add a brand new layer. Suppose the fair coin offers a 150% return on a win but a 100% loss on a failure. The flawed coin, however, offers a 135% return on success but only a 50% loss on failure. Both scenarios lead to an expected return of around 25%, however the flawed coin lets you play again – a vital think about investing.
In investing, risk will not be defined by probability or expected return. The real risk is the likelihood of everlasting lack of capital if the chances turn against you. Therefore, risk should all the time be viewed in absolute terms and never relative to return.
Put simply, as a minority equity investor, there isn’t a return that outweighs the chance of everlasting lack of capital. Since the longer term is unpredictable, avoiding extreme gains is of utmost importance. Rational investing will not be about betting on binary outcomes, irrespective of how tempting the upside. While this sounds easy, in practice it’s way more nuanced.
From theory to practice
Consider a chemical company that has just accomplished a big investment cycle, funded primarily by significant debt. Management is optimistic that the brand new capability will triple money flow, allowing the corporate to quickly pay down its debt and achieve positive net money flow in two years. Additionally, the stock trades at a major discount in comparison with peers and its historical average.
Tempting, right? However, the prudent investor focuses not on the potential upside, but moderately on the bankruptcy risk inherent in a commoditized, cyclical industry, particularly one vulnerable to Chinese dumping.
Now consider one other example. A branded consumer goods company with a historically strong, cash-rich traditional business. Recently, the corporate took on debt to expand into latest related products. Should the brand new product fail, the corporate’s core portfolio will still generate enough money flow to pay down debt. It could be a painful setback, but far less catastrophic. For a long-term investor, this investment could still result in a profitable consequence.
In each cases, the difference lies not within the probability of success, but within the severity of failure. The focus should all the time be on risk management. Compounding causes returns to occur naturally.
Empirical Evidence: Leverage and Long-Term Returns
To re-emphasize this principle, let’s turn to a more practical illustration. I analyzed the performance of U.S. stocks over the past 10 years by creating two market capitalization-weighted indices. The only differentiating factor? The first index includes corporations with net debt to equity below 30%. The second index includes corporations with a net debt to equity ratio of over 70%.
Index 1.
The results speak for themselves. The low-leverage index outperformed the high-leverage index by 103% and outperformed the broader S&P 500 by 23% over the last decade.
Repeating an identical exercise for emerging markets (EM) highlights similar trends, albeit in a narrower range. The low leverage index outperformed the high leverage index by 12% and outperformed the broader MSCI EM by 6% over the last decade.
These results underscore a straightforward truth: Companies with lower debt levels—i.e., lower risk of bankruptcy—are higher equipped to weather downturns and generate higher long-term returns.
Key to remove
Investing will not be about chasing unlikely victories or betting on binary outcomes with tempting benefits. It’s about protecting your capital from everlasting loss and allowing it to grow steadily over time. By specializing in corporations with strong balance sheets and low leverage, we minimize the severity of potential defaults. This prudent approach allows us to weather market downturns and profit from the natural power of rising returns. Remember that risk management will not be only a defensive strategy. It is the inspiration for sustainable, long-term investment success.
