A key element in successful investing is being able to think clearly. Not as easy as you might think – I’ve been struggling to achieve this ability for years. The first step toward clear thinking is the ability to know what words mean in various contexts. Often, it’s not what you originally learned.
Let’s look at one of the most difficult words in the investing vocabulary:
You risk your life when you step out into the street. Fine, but new usages are proliferating. It totally flummoxed me, for example, since I had no idea what the teacher meant, when she said, “These are ‘at risk’ children.” Of course, the world of education is famous for making mush of the English language. I hear they do it in French and German, too, but that’s a subject for another post.
“What are they ‘as risk’ of,” I asked, puzzled. If you are standing on the edge of a cliff, you are at risk of falling off, but that meaning didn’t seem to apply here. “What kind of risk?”
She stared at me. “Why, they are at risk…” louder, “just at risk!” After listening to the discussion she was in at a school meeting, I hazarded a guess that she meant they were juvenile delinquents – itself a euphemism for ‘a bad boy.” It was at risk of flunking out of high school, or at risk of going to jail or worse, prison.
Ah, well, those were the days. The ed establishment has probably already moved on to a new euphemism, since practically everybody has caught on to what ‘at risk’ means.
In the investment world, risk means something else. No snarky comments about jail time, now. Risk, as in taking on more risk than they could handle, meant bad debt. Um, can’t say that, can you? It’s true that all loans contain an element of risk that the borrower will not pay off the loan. But risk soon came to mean ‘reward,’ as in higher profit, because higher interest rates can be charged for higher risk loans. So the word morphed into a synonym, not a euphemism, for interest rates.
Lately, I’ve seen the term used in a slightly different way, a kind of leftward extrapolation of interest rates or rewards. As soon as I figure it out, I’ll post my findings.
Speaking of risk, leverage is another obscure word in the investment world lexicon. No, it has nothing to do with the ancient Greek solution to the problem of moving very heavy objects. “Give me a lever long enough,” said a famous person, “and I can move the world.” If you have a lever such as a crowbar and a fulcrum such as an anvil, you can stick the lever under the heavy object, say a car, press down on the crowbar which is leaning on the anvil and lift up the car.
No, in the investment world, leverage is debt. Many leveraged buyouts depended on massive debt which was paid off with the victim company’s assets, leaving the remaining skeleton for the vulture capitalists to pick. They hardly used any of their own money to buy companies and they got rich doing it. Kind of like printing money. This trick was often used to take a company private, then sell it back to the public again, and sometimes even taking it private again.
Now, in a slight shift of meaning, leverage means issuing more debt to get out of trouble or to buy another company. Instead of organic growth, or growth from within, some company managers prefer to buy smaller, or even larger, companies. This enables the management to get massive exit packages or pay increases.
Fun for everyone except stockholders. The Wall Street Journal ran an analysis several years ago showing that most companies ‘growing’ in this fashion had lower stock prices than before the merger. Now, the market has gotten used to this trick, and you’ll often see a stock price go down, rather than up as they used to do, on announcement of a big merger.
Why? Isn’t the company bigger now, therefore worth more? Maybe. But usually the merger is accompanied by massive new issues of stock, thereby diluting the value of each share.
Say the number of shares doubles and management gets three times as much stock as they were being paid before as a reward for their extra hard work at this bigger company. Say you didn’t buy any more shares, happy in the notion that the price of the stock would go up because the company was bigger. That’s because you weren’t paying attention to the man behind the curtain, filing SEC forms disclosing that the number of shares was doubling, thereby diluting your actual ownership share of the company.
Ah, leverage! Good for some. For others, not so much.