It is essential not to overlook critical assumptions. One of the most basic stock investing beliefs is that firms will continue to exist — firms do not live forever. Beginning as a start-up and ending in decline, firms undergo many changes over their lives. An idea becomes a business that generates growing profits and revenue. As a result of sound investing, the company continues to grow, finds new markets, and fends off competitors. At some point, the demand for the firm’s product or service slows, competition erodes advantages, and the business shrinks. In an age of rapid technological change and business disruption, entire industries can live a decade in an instant. When coupled with heavy debts and leverage, such sudden changes can be a toxic mix for stockholders.

Along the way, businesses fund growth through a variety of sources. Some capital is raised from owners, while other capital is raised from creditors and shows up as debt. So long as the debt goes to profitable investments to drive growth, the debt can be a blessing rather than a curse. But, like a game of musical chairs, if the music stops playing and the value of the firm’s assets starts a process of decline, the chance of default rises. In a default, where debt is not serviced on time, the stock’s value can be completely wiped out. Focusing on companies with low debt and conservative finances can help keep this scenario from playing out in your portfolio.

Low leverage, thus, is an attribute of a “high-quality” company, in our view.

Nature of Failure

The nature of failure risk is peculiar and hard to predict but often arises in recession. Failure risk due to leverage can come on slowly or all at once, and it can happen to well-known and established firms. In every downturn, we hear about such firms that fail to make it to the other side of the economic cycle. One of the most significant risks to a company’s survival is the amount of debt used to finance its assets.

When borrowing drives the accumulation of assets faster than owners’ equity, we can say that leverage has increased. As leverage increases, changes in asset values are amplified down to equity owners, increasing a stock’s volatility and risk. The risk brought about by high leverage can be intensified as the firm transitions in its lifecycle from growth to decline.

History and theory have much to say about how fast the decline and default process can play out. Consider the experience 2007-2009 Global Financial Crisis (GFC), where leverage risks became evident.

GFC Experience

Here is a sampling of high leverage companies that were wiped out, or nearly so, in the Global Financial Crisis of 2007-2009. Note that these firms all have high leverage in common. The ratio of assets to owners’ equity is significant (at or above 10x). Moreover, the leverage was not seen as troublesome to credit rating agencies on the eve of the downturn in late 2006. The credits were all highly rated by Standard & Poor’s rating agency. Yet, once the downturn set in, the losses were far more than what was implied by analysts’ high ratings. The failures were extraordinarily rapid and brought near-total losses for many stock investors.

A Sample of Leveraged Firms
From the Global Financial Crisis

2006 Yr. End Stock Price2008 Yr. End Stock PriceAcquirer
Bear StearnsA29-1$160$9JPM Chase
Washington MutualA-13-1$45$0JPM Chase
AIGAA10-1$60$1U.S. Government*
Fannie MaeAAA20-1$59$1U.S. Government
Countrywide FinancialA14-1$42$4Bank of America
Merrill LynchAA-22-1$93$12Bank of America
WachoviaA+13-1$57$5Wells Fargo
* Majority owner

Source: Standard & Poor’s; Bloomberg

Financial Theory

Analyzing defaults occupies the realm of credit risk analysis in finance. There are many ways to estimate and think about losses and their potential arising from defaults. None of the models in existence offer a perfect crystal ball. Yet, one model helps provide some intuition when looking to understand risks related to a company’s equity and debt. The model is called a “structural model” and comes from Robert Merton, who won a Nobel prize for his work in finance and economics in 1997. If you want to read his original work, you can find Merton’s paper here and a brief summary is presented in the callout box at the bottom of this commentary.

In essence, the model relies on option pricing models to estimate the likelihood of default and views equity as a call on a firm’s assets. The key point is that the probability of default (horizontal axis) accelerates rapidly with high amounts of debt and leverage (vertical axis). Once the value of assets exceeds five times equity value (5x leverage), theoretical default risk accelerates non-linearly. Note that the companies listed in the GFC table above had leverage factors that placed them on the “elbow” part of the curve or higher.

Applying the Model

The above model does have its limitations. Balance sheets can be complex, changing interest rates and economic conditions can impact outcomes, and asset values can’t always be known with certainty. Notably, the model also relies on the assumption that asset returns are “normal,” despite considerable evidence to the contrary. In the real world, asset returns have “fat tails.” This means negative surprises (significant losses) happened more than what would be expected. This is a major reason to err on the side of caution when it comes to investing in indebted companies.


Whether considering financial history or theory, we think there is plenty of reason to play it conservatively when it comes to debt. In today’s world, where debt is rising, “zombie companies” are common, and many industries are being disrupted by new technology. It makes sense to look at how leverage might impact your portfolio.

As this recent Bloomberg article points out, markets are rapidly driving up companies’ prices with weak balance sheets. During a more challenging market, we would expect these companies to underperform those of less indebted, higher-quality firms. Building a “quality” portfolio starts with finding quality companies. There is no better place to start than looking at how firms use debt to fund their businesses.

A Merton Model Summary

A share of stock is essentially equal to a call option on the firm’s assets, with a strike price equal to the debt outstanding. If the firm’s value exceeds the required debt payment, the call will be exercised, resulting in a positive stock price. However, if the value of the firm does not exceed the threshold necessary to service debt owed, the call will become worthless, the firm will declare bankruptcy, and the debtholders will be entitled to the assets with equity owners receiving nothing (other than the right to “walk away”). Corporate finance theory models this behavior using an options pricing model first postulated by Robert Merton in 1974.

Steven Lerit, CFA

Kevin R. Caron, CFA
Senior Portfolio Manager

Chad Morganlander
Senior Portfolio Manager

Matthew Battipaglia
Portfolio Manager

Steve Lerit, CFA
Senior Risk Manager

Paul Clark, CFA
Senior Portfolio Manager
Municipal Fixed Income

Rick Marrone
Senior Portfolio Manager
Municipal Fixed Income

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Internal Relationship Manager

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