Do you remember the Indiabulls TVC? When the speaker at a company AGM is about to conclude, Mr. Kulwant Bhatia raises a query on the impact of raising long term debt in a potentially inflationary economy!
The TVC is funny. No one can be blamed for failing to notice the significance of the question. The contrasting visage of the speaker and the person asking the query with his ‘gotcha’ expression and accompanying glee, perhaps over rules all other thoughts.
This column is not a TVC aimed at making you laugh and help brand recall. This column is to make you think, so we will dissect the query highlighted in the opening para.
We live in times of high inflation. The impact of high inflation is felt when the value of a unit of currency goes down and leaves the owner of the currency ‘poorer’.
Let’s turn around this scenario a little. What happens if you own negative currency? In other words, if you are a net borrower, do you become ‘richer’ if inflation is high?
No one borrows to leave money idle in the bank. You put it in a business or in an investment where you can earn a rate of return which is better than the cost of your borrowing. Without this, you are worse-off borrowing money.
The return that you generate in the business or on your investment (an asset), if it is not fixed (which is likely to be the case) or if the market value of the asset is fluctuating, then there is a risk. The risk is of losing money. Either, the returns may fall below the cost of borrowing or the asset value may fall below the cost of the investment.
If you have an asset that has less chances of either risk coming true, and which is not difficult to sell (demand outstripping supply), then, it is safe to assume that an injection of borrowed capital for financing will enhance the return on own capital.
This is a simple principle of ‘leverage’ at work. The term is derived from physics where a lever is the simplest form of a machine at work, the output is magnified or multi-fold that of the input.
To further control the risk, try coupling the target asset with an asset that historically has a weak or negative correlation. Do you have a winner in your hands?
This does not mean you have a perpetual winner in your hand as any of the following things may happen - Rate of interest shoots up, inflation falls, return on asset and/or asset price falls.
The trick lies in balancing the risks and getting a return which is an adequate compensation for the risk. Timing the ‘exit’ from the strategy also becomes important. Reducing the leverage, if not wiping it completely is easier than exiting the asset. Do not wait for peak price, peak returns, and lowest rates of interest or highest rate of inflation.
Are you wondering what that dream asset could be? Well, how about your own business!
Very well said
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