The most dangerous gift in finance is leverage. Over the last five years, I have frequently read, heard, or written words to the following effect:
Excessive debt is a red flag. On the stock market, credit yields fantastic results if you are right, but produces equally destructive, leveraged losses if you get it wrong. So, leverage magnifies upside; BUT, it also magnifies downside.
Amidst the coronavirus turmoil, I have finally learned this from a first-hand experience as I have exited my investment in Aston Martin (at a notable 42.5% loss). One of my favourite adages says "When you don't get what you want, you get experience". And I have every intention of making this experience count. So, in this post, I will detail my experience and reflect on what I have learned.
Aston Martin Lagonda - the journey
My investment thesis was simple and I still believe each of the following is true.
- AML is a heritage brand with a notable following.
- Company has invested in good products, and is launching one new car per year.
- Company has invested in good products, and is launching one new car per year.
- Exclusive specials, F1 participation, and mid-engine cars will elevate the brand.
- SUV (the DBX) broadens appeal, and should increase volumes.
Then why exit? One word: LEVERAGE.
Aston Martin is a highly levered company (even after factoring in a recent rescue investment by Lawrence Stroll and the upcoming rights issue). When I invested in AML, I was aware that leverage magnifies the upside and the downside; but, I was mostly focussed on the upside, because the stock had been cratering, and the company looked incredibly attractive.
However, despite believing in the long-term story, I am unsure whether Aston can survive amidst the challenging climate of the covid-19 induced economic disruption. As it shuts factories, revenues will fall, losses will grow, and the business will be pushed closer to the brink of default and bankruptcy. Equity holders can potentially get wiped in such a scenario. This is why I chose to sell my shares in AML and invest the proceeds in a compelling business with a far stronger balance sheet.
So what lesson did I learn from this experience?
You need a FORTRESS BALANCE SHEET, because it can allow a firm to weather a storm. I have taken an edited excerpt from a previous post to explain my thinking in more detail.
Risk = (Hazard x Vulnerability)/Capacity to Cope. This allows us to distinguish between a hazard or bad event and the factors that determine the level of risk posed by this event. A strong company, by which I mean one that is not using performance enhancing drugs (leverage), has a higher capacity to cope with a bad event, and may even be less vulnerable to a bad financial event. And, because bad things happen to good companies (all the time) a fortress balance sheet is non-negotiable.
I once said, "Predicting rain doesn't count, but carrying a coat does". To me, maintaining a fortress balance sheet is the equivalent of carrying a coat. In fact, a strong balance sheet is more than just a protective coat; it is also a weapon. A company which has a strong balance sheet will likely outlast a levered competitor and so will benefit from the levered company's demise. Furthermore, having cash on hand (or at least favourable access to capital markets) can allow firms to strategically acquire businesses that are on sale. So, a fortress balance sheet allows companies to bounce back stronger than they were before the crisis.
As a result of this experience, I am particularly sensitive to the importance of a solid balance sheet. I hope never to repeat my mistake of investing in a highly levered business. In good times I might end up seeming a stubborn fool; but, when the tide goes out (for it inevitably will), I don't want to be caught swimming naked.