How We Think

The Danger of Leverage

As value investors, we make the assumption that the market is irrationally pricing a security now, and we expect the market to value the same security more rationally in the future.  However, we have no expectation nor guarantee that the market will not value a security substantially more irrationally in the interim.  The intrinsic value of a security is the discounted value of all future dividends (John Burr Williams).  We assume that securities trade in some mound-shaped distribution whose mean is the intrinsic value and which may or may not be normally distributed.  Given this set of assumptions, we believe cutting off one of the tails by using leverage will lead to bankruptcy in the long run.  The long run might be one thousand years, but the math still dictates that such a strategy will inevitably result in ruin if you believe that there is no limit to how irrationally a security can be priced either in magnitude or over time.  Additionally, the more leverage that is used, the more of the tail that is cut off.  Borrowing money to buy assets necessarily narrows the range of deviations from intrinsic value an investment can have without causing bankruptcy.  Finally, psychological factors frequently cause participants to underestimate the likelihood of “rare” events such as the proverbial “hundred year flood” by a factor of ten.  We will not employ a strategy whose long run expected return is negative 100%.