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the buy side

If you have been reading this column for a while, you know my opinion that risk is not just price volatility (although it's good to minimize it, to sleep well). Rather, the biggest investment risk is ignorance. Not doing your own due diligence often makes you substitute "opinion" for facts, and is, in essence, gambling rather than investing.

However, there's another form of risk that seems not entirely clear - leverage. From e-mails I received from two hedge fund managers, I deduced that each was superlevered but neither considered himself so. It made me wonder: If some pros can make such errors, what about non-pros?

Therefore, to make sure you don't inadvertently lose your investments, here's a recap of the two main leverage risks: financial and operational. And, as you'll soon see, the latter can also provide an opportunity.

Let's start with financial leverage. In its basic form, it is simply buying on margin. You buy a stock for $20 but only put up $15, borrowing $5 from the broker. If the stock rises, you make more on your money. If it falls, you lose more. In market parlance it is also called "torque" and most investors should avoid it.

However, some managers (like those who e-mailed me) insist they can minimize margin risks if they balance longs with shorts. Say you have $10. You buy one stock for $8, then borrow another stock at $8 and sell it short. Your net long position is zero, but you are really 60-per-cent margined. And your market risk is still high, because what if both your picks are wrong? What if the long goes down and the short up? You could lose a lot in a hurry.

To make it worse, some hedge funds use even higher leverage, such as 130 per cent long/100 per cent short. Their pitch is: We are only 30 per cent net long and so should fluctuate less than the market while giving you higher returns. So, on a risk-adjusted basis you are better off. But is this true? Nope. Risk is not volatility. Such a fund's market exposure is 230 per cent, so if they are wrong on both longs and shorts, the portfolio can melt - as many such did last year. Further back, in 1997, Long-Term Capital Management went bust carrying high long/short leverage to a ridiculous extreme.

Which is why good hedge fund managers always look at two key ratios: long exposure (long minus short, divided by total assets); and market exposure (longs plus shorts, divided by total assets). The first ratio indicates how bullish (or bearish) they are. But the second ratio indicates how safety-conscious they are. If you invest in a hedge fund, knowing the first ratio (net long/short exposure) is only half the story. Better find out also the fund's market exposure - i.e. its true leverage. If it's high, just as it rose fast, it can plunge fast.

Now for operational leverage: Unfortunately it is not one you can compute easily, yet it can decimate your portfolio just as quickly as financial leverage. In simple terms, operational leverage is the increase in a company's profit (and thus its stock price) due to increases in the price of a key product, or a commodity, or volume of sales. Obviously, it is closely related to cost structure. For example, say you are bullish on gold, and have a choice between two companies: one with low production costs, the other with high costs. The first makes money now. The second barely does. But if the price of gold rose 10 per cent, the first company would make 10 to 15 per cent more profit, the second's profit - starting from a low base - could double or more. Thus buying an operationally levered company is similar to buying a call option - here, a call on gold price. Of course, if gold prices fell, the second company's stock would plunge. Thus if you own stocks of operationally levered companies, your financial leverage may still be low (you haven't used up all your cash), but your portfolio's operational leverage would be high - it's as if you had filled your portfolio with call-option equivalents. Very risky.

How can you gauge your portfolio's operational leverage? Not easily. Unlike financial leverage, you can't just compute it by looking at your brokerage statement. Better talk to your portfolio manager (remember due diligence?) and ask about his or her investment philosophy. Some, even those who never use margin, like to buy operationally levered plays, others don't. If you invest on your own, ask the company. You can bet they know their break-even point in their bones.

And now the bonus point: Operational leverage is not just about risk - it can also provide an opportunity. Say you found through your sleuthing that a manufacturer had cut its break-even point a lot - through drastic layoffs, plant closings and new technology. Like car companies did last year. If you later called car dealers and learned that showrooms are filling up, you'd know that car makers' profits could soar more than others expect - and in this case, operational leverage risk would turn into opportunity. And all because you did your due diligence.

See? I told you it's worth doing.

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