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Opus News & Insights

Profit Owed to Leverage
Thursday, October 13, 2016

At the end of Q3, Russell 3000 Stocks with below average Leverage underperformed the index over the past 5 years by over 6%.  Most of the underperformance happened after the interest rate on US 10 year Treasuries dropped from their high of 3.03% on 12/31/13.  Since that time, lower than average leveraged companies have returned 12.5% compared to the Russell 3000 return of 21.5%.  Looking at the attribution, the sector weighting of the lower leverage stocks actually helped returns during the period so neutralizing sector weights will make the underperformance greater.

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It is not too surprising that the low interest rate environment supports companies with the highest leverage as rates drop. Low rates allow companies that normally may have gone out of business due to low return on capital to stick around. These inefficient businesses can actually make profits with the greater amount of low cost leverage available to them. For some businesses, lower financing costs reduce the incentive for capital investment to increase productivity. This is likely one reason that the Labor Productivity index has dropped an average of 0.6% since 2014. Having companies continue to operate even though they are inefficient and deferring capital expenditure is good for the labor markets as we have seen. However, the profitability of these companies is very sensitive to changes in interest rates which could lead to a large market drawdown if rates start to climb. The Federal Reserve (FED), likely very cognizant of this relationship, continues to support low rates to keep the employment figures elevated and trades higher potential GDP for a more stable current economic picture.

An assumption one may make of the recent positive asset flows into minimum volatility products is that market participants are protecting their gains from a market downturn. As of the end of Q3, the portfolio of the top 10% of stocks with the lowest 200-day volatility has greater leverage than the market. With interest rates at record lows, the historical markets used in back testing may fail to produce the statistical results that quantitative strategies advertise. The promise of downside protection may fail in these strategies if leverage becomes a dominating factor in market return.



 
 
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