Analyze Yourself As A Company. Do You Have A Wide Moat? (2)

By Alfaris88 (Own work) [CC BY-SA 4.0 (http://creativecommons.org/licenses/by-sa/4.0)], via Wikimedia Commons

All Time Sleeping Average: (Target) 7h30m / day (Actual) 7h33m / day (154 night average)

3 Day Sleeping Average: (Target) 7+h / day (Actual) 6h30m / day (5h14m, 7h33m, 6h43m)

I wrote about the different aspects that one should consider in evaluating the financial health and value proposition of themselves in the previous article, but focused on the concepts rather than the specifics. This post attempts to delve deeper into the specifics.

I talked about how having minimal to no debt and a shit-ton of cash allows to patiently wait for the right opportunity to make the most optimum decision over the long term. So how much debt should you be able to take, and how much money should you target to always have?

Today I’d like to talk about the specifics of debt.

How much debt you should be able to take is dependent on a few factors, and the theoretical maximum from each factor combined together will give you a good idea:

  1. What is the purpose of your debt?
  2. How do you intend to invest with your debt?
  3. What is the interest rate of your debt?
  4. What is the monthly repayment amount of your debt? What’s your ability to repay?
  5. By when does the debt need to be fully repaid?

1. What is the purpose of your debt? I strongly believe in the difference between good debt and bad debt. If the debt you take on is not going to directly influence your financial well-being, then you shouldn’t take it on at all.

2. How do you intend to invest with your debt?If you are going to be a very concentrated investor, you should not use leverage.” If you’re going to run a diversified portfolio, what kind of investments will you make? A reference point is Warren Buffett’s leverage rate of 1.5x for Berkshire Hathaway. Warren Buffett’s alpha is generated by investing in low beta and high quality stocks at cheap valuations with low cost debt.

Putting aside the cost of your debt, if Warren Buffett’s leverage rate is 1.5x because he invests in low beta and high quality stocks at cheap valuations and we assume he is the golden standard of safe leveraged investing, then you should scale back your leverage rate based on that reference point depending on how much lower in quality (eg. Net Net Stocks) or how much higher in valuations you’re willing to go for (eg. Relative Valuation of Magic Formula vs. Market which could still be overvalued in absolute terms).

3. What is the interest rate of your debt? Another aspect of Warren Buffett’s leverage rate is that his debt is mostly from the float provided by Berkshire Hathaway’s insurance operations which consistently underwrite profitably. In other words, Warren Buffett is paid to borrow whether or not he ends up using the debt for investing. Similar to the previous exercise, you should scale back your leverage rate based on that reference point.

Another thing to note is, whatever you intend to do with the debt must produce financial returns that far exceed the interest rate of your debt, with the excess margins dependent on the volatility of your investment strategy (the higher the volatility the higher the excess margin you should demand). Volatility is risk when you are forced to sell, and if you can’t service the debt fully from your income streams or your NNWC, then most likely the repayment must happen from liquidating the investments you made.

4. What is the monthly repayment amount of your debt? What’s your ability to repay? A good reference point from Financial Samurai is to allocate 10x interest rate percentage of savings to service debt (eg. if 1% then allocate 10% savings). That in itself should allow you have a ballpark figure of how much debt you can take on.

Another aspect is your ability to repay. Let’s say you do allocate 10x interest rate percentage of savings to service debt, but it still wouldn’t make sense if your monthly salary was irregular or your job nature was volatile. This is when you have to also consider the other aspects of repaying debt, namely any additional sources of income you have and also your NNWC (Net Net Working Capital).

Let’s just say your monthly salary was irregular and your job nature was volatile, so you use a 50% discounted figure to estimate your ability to service your debt. Then you realize you own a bunch of dividend aristocrat stocks and use a 80% discounted figure to estimate the monthly dividend contributions from such stocks.

Combined together, you shouldn’t exceed the 10x interest rate percentage rule, but just to err on the side of caution, you also make sure your NNWC (100% value for cash, 75% value for receivables & bonds, 50% value for equity investments) should last you for as long as you need to find your next job just in case the monthly salary get completely eliminated and only your dividend aristocrat stocks’ monthly dividend contributions remain.

5. By when does the debt need to be fully repaid? There is a trade-off between how low the interest rate of debt goes and how long you can take to fully repay the debt. All things equal, if interest rates are the same, you should always delay paying the debt.

As mentioned earlier, volatility is risk when you are forced to sell, and since if you’ve done your homework and know that your investment strategy works on the long run, then you minimize the risk of having to liquidate investments during a down year for the investment strategy by extending the period to let the strategy work before you liquidate investments to repay the debt.

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