Risky Business (Part 3)

What else can MF Global teach us about risk?

Investment returns are based, not on optimism, but on arithmetic. Whether it’s growth investing, value investing, or bond investing, return on investment is a matter of math. It may seem like a “dark art,” but calculating investment return is actually fairly straightforward: take the company’s expected revenues, subtract its operating costs, and you have the operating margin. Take out interest expenses, depreciation and taxes, divide by the number of shares outstanding, and you get earnings-per-share.

Now, different businesses have different characteristics: how fast they’re growing, how regulated they are, what the competition is like. These factors play into what management will do with the cash. Usually, some of that cash comes back to shareholders as a dividend, and some gets reinvested into the business.

With bonds, your upside is limited. You should have strong evidence that whoever issues the bond will have the cash necessary to pay the bond off when it matures. When MF Global bought peripheral European debt, management expected that surely the rest of Europe would not allow their partners to default. On a mark-to-market basis, though, those bond prices crashed as investors worried about the Euro.

MF Global was levered over 25 times. When your equity is that thin, a little price fluctuation can wipe you out. Investors need to acquiesce before the inexorable power of math: the greater your leverage, the less risk you can afford.

Douglas R. Tengdin, CFA
Chief Investment Officer
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