Why investors must think about debt in volatile times

By Tom Bradley

I’m a voracious reader of business, technology and economics, but the more I understand the issues and trends these days, the more out of control I feel. You know what I’m referring to: artificial intelligence, international tensions and conflict, short-sighted government policy and power concentrated in fewer hands that aren’t accountable to voters or shareholders.

It feels worse than usual, although it’s not as if investors ever have much control. Returns are always dependent on a myriad of unpredictable factors that interact in unpredictable ways. If you think you’ve figured the markets out, you’re kidding yourself.

So, what to do? At times like this, I go back to a pile of reports and articles on my desk labelled “Keep.” It focuses me on investment fundamentals such as growth and profits instead of politics and speculation. It provides perspective on how long markets can stay off trend and/or act irrationally. And it usually includes something about, or written by, Warren Buffett.

While diving into the pile last week, a number of things jumped out as being relevant to today’s investment landscape.

First, my time frame (and most of our clients’) is exceedingly long. Most of what is perplexing today won’t even show up on a chart of my portfolio in 20 years, or even 10.

There’s plenty of stuff on valuation. A quote by James Montier of U.S. asset manager GMO was highlighted in flaming pink: “Valuation is the closest thing to the law of gravity that we have in finance. It is the primary determinant of long-term returns.” The reminder comes at a time when price is taking a back seat to stories and hope.

The topic that resonated most, however, was debt. That’s because leverage in individual and institutional portfolios is at an all-time high. Hedge fund strategies and private asset returns are highly dependent on borrowing, and more individual investors are using margin accounts.

Debt is a Jekyll and Hyde topic. It’s easily forgotten when things are going well and is the only thing that matters when they’re not.

It exaggerates outcomes in both directions, juicing returns on the way up and amplifying losses on the way down. But the impacts are far from equal.

Upside is easy and feels wonderful while it’s happening. For the 40 years prior to 2022, homeowners were giddy watching their net worth steadily rise. They couldn’t believe their good fortune.

It follows then that when prices go down, losses in levered portfolios are worse, but that’s just the beginning. Things can get difficult fast.

It’s psychologically harder to hang in and stay invested when your net worth is disappearing (or is negative). Exponentially harder.

And you’re not the only one who has to hang in. Your lender, whether it’s a bank or investment dealer, also has to stay the course. Unfortunately, they never do. Before long, you’ll get a call asking you to either stump up more money or sell something.

But that’s not the end of it. After you deleverage, your ability to recover is impaired. You’ll have less capital invested because you’ll be less willing to use debt a second time around, and even if you are, your lender is less likely to provide the credit you need.

It’s a bad formula – going back up with less invested than you went down with.

This asymmetry of outcomes was front and centre in a discussion I found between Howard Marks, founder of Oaktree Capital, and Morgan Housel, a bestselling author and behavioral finance guru. They talked at length about investors’ durability and endurance. At one point, Mr. Housel said: “The more debt you have, the narrower the range of bad outcomes you can survive.”

Mr. Marks’ words from two years ago spoke to the current tension between AI’s risks and unknowns and the increased use of debt. He said, “A highly leveraged capital structure cannot co-exist with highly volatile assets. If you want to buy volatile assets, your capital structure should be conservative. If you want to use leverage, you buy conservative assets.”

They differentiated between maximizing (“trying to get the most you can, the soonest you can”) and optimizing (“the best returns that you can sustain for the longest period of time”).

Right now, there’s a lot of maximizing going on, with the increased use of leverage and options. My fundamental reset, however, tells me investors should be doing the opposite. Volatile stock prices and changeable AI narratives point toward optimizing. Make sure you can stick to your plan, no matter how this technology revolution plays out.

Tom Bradley is a portfolio manager with Purpose Investments, co-founder of Steadyhand Investment Management, a member of the Investment Hall of Fame and a champion of timeless investment principles.