Why Debt is Actually Really Good
If you're a thematic investor, that is
Hello!
Today I give a one minute non-consensus take on why corporate debt is actually really good. Enjoy!
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Consensus says debt is always bad. “Net cash” and “fortress balance sheet” are the biggest green flags to most public markets investors.
Or one can cite Modigliani-Miller and argue “well actually it doesn’t matter because WACC never changes!”
The academic argument behind this is pretty simple. Debt and equity are both ways of financing a business. As stock market investors we own the equity. If the company is levered our equity is more risky. If the company is unlevered it is less risky. But it actually doesn’t matter because with the more levered business you can just own it in a portfolio with cash and for the unlevered business you can lever up yourself.
Essentially, because the investor controls their own leverage, the leverage chosen by the company doesn’t matter.
Moving from the theoretical world into the real world, the only variables left are the debt tax shield (positive for debt, WACC goes down) and the risk of bankruptcy (negative for debt, WACC goes up) which act as countervailing forces, meaning companies in a certain industry usually have an ideal level of leverage that minimizes WACC.
So that is the foundation. How will we challenge it?
I am a thematic investor. I believe in the future of AI and by extension the semiconductor industry. Many hedge funds do the same. Our jobs are to express our thematic view to the fullest extent without taking on excessive risk.
Why the excessive risk clause? Well, if I lever up my portfolio 5 to 1, I’ve just introduced massive path dependency. Those of you who read my shorting article know what I’m talking about. I could be totally right about the destination, but now because I’m levered, I’m dependent on the path, specifically that of the share price.
As all value investors tend to scream at us growth guys for, price does not always equal value. You can be right on the value, but if price takes a drawdown and you get margin called, you are fucked. This is why we must manage risk.
But see, we just talked about the investors’ ability to lever up as a reason why corporate leverage is irrelevant right?
“If the company is levered our equity is more risky. If the company is unlevered it is less risky. But it actually doesn’t matter because with the more levered business you can just own it in a portfolio with cash and for the unlevered business you can lever up yourself.”
My argument breaks this exact premise. Investor leverage is NOT the same as corporate leverage. Investor leverage introduces path dependency to the price while corporate leverage does not. For a corporation to go bankrupt, they must be unable to service their interest with cash, i.e. the value must go to zero. One is price, the other is value.
For thematic investors, this is profound. With leveraged corporations, you can get more exposure to your theme (and the direction of fundamental value) without taking on the path dependency that comes with individual leverage! Higher expected returns (provided you are correct on your thematic) with no path dependency (hold through drawdowns without fear of margin calls).
Below, I’ll share a name I’ll be entering next week (and writing up sometime) that applies this principle to the tee.