Understanding Financial Leverage

According to Physics, leverage is the force needed to lift and, if necessary, move loads. Leverage in finance works in similar ways as it works in physics. It amplifies the return.

 

Financial Leverage: Understanding the Power of Borrowed Funds

Financial leverage is a strategic approach used by both individuals and businesses to potentially enhance returns on investments. Here’s what you need to know:

1.Definition:

o    Financial leverage involves using borrowed funds (such as loans or debt) to invest in assets, with the expectation that the gains from those assets will exceed the cost of borrowing.

o    Essentially, it’s about borrowing money to make more money.

2.How It Works:

o    Imagine a company that wants to expand its operations but lacks sufficient equity (ownership capital) to fund the expansion.

o    Instead of relying solely on its own funds, the company borrows money (e.g., through loans or issuing bonds) to finance the expansion.

o    By doing so, the company aims to generate returns from the new assets that exceed the interest payments on the borrowed funds.

o    Let us do the mathematics:

Suppose a company/individual investing 100 rupees can earn 20 rupees return. Suppose further interest rate is 8%. Now if the investor borrows 100 and invests 100 rupees of his own, he will be able to earn 40 rupees on his combined capital of 200 Rupees. But he must pay 8 Rupees interest as well. Thereby after returning the borrowed funds and paying off the interest the investor made 32 rupees profit using his 100 rupees.

3.Benefits:

o    Financial leverage allows businesses to:

§  Accelerate growth: By leveraging borrowed capital, companies can invest in projects, acquisitions, or new ventures.

§  Amplify returns: If the investment performs well, the gains are magnified due to the borrowed funds.

§  Optimizes the capital structure: Balancing equity and debt helps optimize the overall cost of capital – i.e. keeps the overall cost of capital to minimum.

4.Risks and Considerations:

o    While financial leverage can boost returns, it also increases risk:

§  If the investment doesn’t perform as expected, the company still has to repay the borrowed funds.

§  High leverage can lead to financial distress if interest payments become unmanageable.

§  Leverage amplifies both gains and losses, so it’s crucial to assess risk tolerance.

5.Leverage Ratios:

o    Common leverage ratios include the debt-to-equity ratio and the debt-to-assets ratio.

o    These ratios help evaluate a company’s reliance on borrowed funds and its ability to cover debt obligations.

6.Personal Leverage:

o    Individuals also use leverage (e.g., mortgages for real estate) to invest in assets like homes or stocks.

o    The goal is to benefit from asset appreciation while managing debt responsibly.

Financial leverage isn’t inherently good or bad—it depends on the context, risk appetite, and the specific situation. Whether you’re a business owner or an investor, understanding leverage is essential for making informed financial decisions

 

Investing strategies of successful investors

Let us learn about various Investment strategies and successful investors who followed these strategies. You can follow any or combination of below strategies to become successful investor.

investment strategies:

1. Growth Investing:

o    Focuses on buying equities (usually stocks) with high growth potential.

o    Short-term growth involves quick gains, while long-term growth aims for steady appreciation over years.

2. Value Investing:

o    Seeks undervalued stocks—those selling below their intrinsic worth.

o    Investors believe these stocks will eventually rise to their true value.

3. Income Investing:

o    Generates steady income through investments like dividend-paying stocks or bonds.

o    Less risky than some other strategies.

4. Dividend Growth Investing:

o    Targets companies with a history of increasing dividends.

o    Balances income and potential for capital appreciation.

5. Contrarian Investing:

o    Contrarians go against market sentiment.

o    Buy when others sell, and vice versa.

6. Indexing:

o    Passive strategy: Invests in broad market indexes (e.g., S&P 500).

o    Low-cost, long-term approach.

Remember, the right strategy depends on your goals, risk tolerance, and time horizon.

 

For more details, you can explore resources like SmartAsset’s guide on [different investing strategies]¹ and WallStreetMojo’s breakdown of [top investment strategies]²

Some successful investors who have followed the mentioned investment strategies:

1. Dividend Growth Investing:

o    Warren Buffett: The legendary investor and CEO of Berkshire Hathaway has emphasized the importance of long-term investing and quality dividend-paying stocks. His portfolio includes companies like Coca-Cola, Apple, and Bank of America, which have consistently increased dividends over time¹.

2. Value Investing:

o    Benjamin Graham: Known as the “father of value investing,” Graham’s principles influenced later successful investors like Warren Buffett. His book “The Intelligent Investor” remains a classic guide for value investors.

o    Warren Buffett: Again, Buffett’s value-oriented approach has made him one of the most successful investors in history. He use to seek undervalued companies with strong fundamentals.

3. Growth Investing:

o    Peter Lynch: The former manager of Fidelity’s Magellan Fund achieved remarkable success by investing in growth stocks. His philosophy was to invest in what you know and hold for the long term.

o    Philip Fisher: Fisher’s book “Common Stocks and Uncommon Profits” emphasized investing in high-quality growth companies with a long-term perspective.

4. Indexing:

o    John Bogle: Founder of Vanguard Group, Bogle popularized index investing. His creation of the first index fund (Vanguard 500 Index Fund) revolutionized the industry.

Successful investors often combine elements from various strategies, adapting their approach based on market conditions and personal goals. 🌟 For more insights, explore resources like Forbes Advisor’s article on [growth investing alternatives]² and The Balance’s guide on [making money with dividend growth investing]³. Happy investing! 📈

 

 

Why should one invest in mutual funds?

Wealthy people have their wealth in form which offers them returns. The forms in which wealthy people park their money is real estate, bonds, debentures, mutual fund units, shares and stock along with others.

Take the example of shares which are in fact part ownership of corporations. If you invest in shares of a corporation you in fact own part of it thus taking part in its future profits and losses.

If you invest shares of Cement Company, you expose yourself to risks affecting the cement industry negatively. Moreover, there are some factors that can affect your company specifically like bad management, technological obsolescence and others.

In order to reduce company specific risk exposure, you need to invest in a number of companies. Likewise, if you want to reduce risk exposure to a certain industry you need to invest in different industries.

The more variety of shares you purchase the less risk exposure you will have. Reducing your exposure to risk by way of investing in multiple securities is called diversification.

Diversification when rightly implemented can reduce your risk exposure. But there are costs associated with buying number of different securities e.g. cost of ordering, accounting, etc. In order to get full benefit of diversification you need to invest a large amount in different securities. An individual has limited amount of capital and cannot diversify, which keeps him away from investing.

The problem of small capital can only be overcome by pooling of funds by different interested individuals. But how to pool funds and also the issue who would manage the funds on behalf of investors arises.

The answer to all these questions can be overcome by utilizing a vehicle called mutual fund.

Mutual funds are pool of funds managed by fund manager for the benefit of isolated investors, who don’t have expertise in the investment field.

When you invest through mutual funds, you benefit from the expert management. The analysts working for the mutual fund industry generates financial models which grows your capital as well as provides protection to your capital.

With Mutual fund investing you also get benefit from diversification, and economies of scale.

The one thing anyone interested in investing through mutual funds should keep in mind that the return from mutual fund is dependent not only on the financial markets performance but also the overall economic performance.

So start investing with good mutual fund manager and select the mutual fund after due diligence.

Disclosure: any thing/ content isn’t substitute of professional advice and the blogging team isn’t responsible for any loss/ damage resulting from acting on information from this blog.

Investing through mutual funds and its benefits

In an article, I have written about benefits of diversification. But small investors face the problem of spreading out their small investing capital across different industries. If you are small investor you cannot diversify effectively owing to variety of factors like having to pay service fees like brokerage commission, minimum investment to be made in one particular security.

The solution to above mentioned problems can be solved by investing through mutual funds. Mutual funds are investment vehicle made up of pool of moneys collected by large number of investors for the purpose of investing in securities, bonds and other financial markets instruments.

There are many benefits of investing through mutual fund. When you invest through mutual funds, you get to enjoy the benefits of diversification. Your mutual fund asset manager has enough capital to invest across variety of assets, hence delivering you the benefit of diversification.

Another benefit of investing through such vehicle is enjoying economies of scale. Your fund can bargain discounted prices for investments. Moreover, other favorable terms can also be agreed because of increased collective bargaining power.

Your fund manager is a professional manager who has learnt about investing through experience and university learning. He is therefore better able to manage your money in a professional style. He can diversify using various statistical techniques. The third advantage of investing through mutual funds is being able to use the skills of professional manager.

There are as many as 40 mutual funds registered with SECP. You can invest in any of the funds mirroring your preferred style of investing.

Some of the funds use aggressive style of investing. They try to generate more returns but the down side is that they are more risky. Some others are income funds, which target generating regular income along with securing your capital.

There are sector funds which invest in specific geographical territory or specific industry e.g. energy mutual funds invest only in stocks and bonds of energy companies. They don’t invest in other industries. As a fund become more specific towards particular territory or industry, its ability to diversify reduces. Try to invest in funds which have consistent track record of generating returns. Although the returns generated by mutual funds are dependent on performance of stock markets.   

There are two types of funds 1. Open ended mutual funds 2. Closed ended mutual funds

Open ended funds are available over the counter and bought and sold on demand. Their net asset value (NAV) is calculated at the end of every trading day whereas closed ended funds are those which are only available on the stock market and has fixed number of shares.

Investing strategies: used by billionaires to amass their fortunes

There are many investing strategies, which investors use. Value investing, contrarian investing and growth investing are mostly used investing strategies. Let’s briefly study them.

Value investing is the most successful investing strategy. It was founded by Benjamin Graham, mentor of Warren Buffet. In this strategy investors see for underpriced securities based on some formula other than market price. This formula for ascertaining the value of the security is generally some multiple of income of the corporation. Value investors usually have to wait for longer in order to realize the full value of their assets.

Along with Warren Buffet many other successful investors follow the value investing strategy of investing. According to researches value investing proved to be the most successful way of investing.  Many billionaire investors favor value investing over other forms of investing. Warren Buffet, Howard Marks, Seth Andrew Klarman, Charles Brandes, Walter J. Schloss, Irving Kahn, Mario Joseph Gabelli, Michael F. Price   are some of most successful value investors.     

Another strategy is contrarian investing. Contrarian investing is buying when other people are selling and selling when other people are buying. Every up and down in the overall stock market or some specific share price offers opportunity of selling and buying to these contrarians respectively.  Warren Buffet is also sometimes referred to as contrarian investor, owing to the obvious reason of many similarities between contrarian and value investing strategy. Other famous proponents of contrarian investing are Michael F. Price, James Beeland Rogers, Marc Faber, David Dreman, Mark E. Ripple, and William Albert Ackman.

Growth investing is another strategy which many successful investors use.  Those who follow growth investing strategy invest in companies that show above average growth even when their shares seem to be highly priced. Unlike value investors, growth investors buy stock in companies that are trading higher than their intrinsic value-assuming that the intrinsic value would grow eventually exceeding current valuations. These investors focus on capital appreciation. Venture capital funds can be classified as growth investors.