Does Financial Leverage Make Stocks Riskier? Part II

Or asked differently, can companies boost returns via leverage?

March 2021. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • The most leveraged stocks were not riskier than the least leveraged ones on a cross-sector basis
  • However, this changes when portfolios are created sector-neutral
  • In this case, the least leveraged stocks also generated higher returns and risk-return ratios

INTRODUCTION

Most investors assume that higher risk is rewarded with higher returns. Take the equity risk premium as an example, which contains risk as well as premium in its name. It implies that the risk from owning equities is compensated with a premium, compared to zero-risk investments like cash.

However, within equities, the relationship between risk and return is not linear. The Low Volatility factor is academically well established and documents that more volatile stocks do not outperform less volatile ones, at least on a risk-adjusted basis.

Some investors might argue that volatility does not equate to risk, but taking a different metric like financial leverage yields similar results. We recently highlighted in a research note that the most leveraged stocks in the US did not outperform the least leveraged ones between 1980 and 2018. 

Having said this, taking leverage as a measure of risk can also be challenged as companies from certain sectors like utilities can sustainably carry higher leverage than others given predictable cash flows. Perhaps the reason for the lack of outperformance of more leveraged stocks is simply due to certain sector biases.

In this short research note, we will analyze the impact of leverage on the risk and return of US stocks on a sector-neutral basis (read Does Financial Leverage Make Stocks Riskier?).

FINANCIAL LEVERAGE ACROSS SECTORS

In this analysis, we are focusing on all companies listed in the US stock market in the period between 1980 and 2018 and measure their financial leverage by three metrics: debt-over-equity, debt-over-assets, and debt-over-EBITDA. Specifically, we focus on the 10% most and least leveraged stocks.

We observe that listed US companies increased their leverage across sectors over the last