There is much in common between financial markets and physics.
The apparent similarities can be as simple as arguing that share prices, like electricity, follow the path of least resistance.
Gearing, however, takes us into the world of motor mechanics.
Gearing is the relationship between an input and an output. When you press the accelerator, how much faster do you go? It all depends on the gearing.
In the financial world, the word has morphed into being a generic reference to levels of borrowing – ‘look at the gearing on that!’ – but its origins lie in GCSE engineering.
If we apply the concept of the accelerator to a company’s sales, the gearing ratio tells us what should be happening to the output – its profits.
Gearing is typically measured as the ratio of a company’s borrowing to its equity (or permanent capital). Thus, if we set up a new business with £1m of our own money and £1m from a bank, we would be said to be ‘100 per cent geared’.
Big deal, you say, but what does that mean?
Well, we have borrowed the money to create a business twice as large as we would have done if we had used only our own cash. Thanks to the bank we get a business twice the size.
Once we have paid the interest on the loan, every bit of profit from the extra sales belongs to us. We make profit from someone else’s money. It is a brilliant plan.
The logic should therefore follow that the higher the gearing, the more profitable a business should be.
If this sounds silly, remember it is precisely this logic that allowed everyone to borrow beyond their eyeballs in the previous decade in the belief that there would be no return to boom and bust. Without any bad times ahead, infinite gearing was the future.
Returning to the car analogy, this Goldilocks era was the equivalent of driving flat out on an infinitely straight road… that then turned all bendy.
And we all know the perils of having an awful lot of borrowed money when (a) the bank wants it back and (b) business is terrible.
Almost every business borrows. The trick is not owing too much when everything goes horribly wrong.
What works, or doesn’t, for business also applies to fund management. Investment trusts (unlike open-ended funds) can and do borrow.
The idea being that by slipping into a higher gear when markets are good, trusts can go into overdrive. Again, there is sound mathematical logic. If the market rises 10 per cent, then a portfolio might also rise 10 per cent. If the fund were 100 per cent geared, then its value would rise (minus finance costs) by 20 per cent. Easy-peasy.
If markets rise, then surely the higher the gearing the better?
Well yes and no. Markets, like economies, fluctuate. Gearing can be like sailing at full sail: wonderful with the wind behind you but not great when you’re trying to navigate against it.
Trusts with gearing, of course, will tend to perform better when the markets are rising. But debt is frequently fixed term and cannot be paid back on a whim.
Managers tend to be natural optimists and those charging fees on gross assets have a vested interest in borrowing as much as possible.
Thus gearing is an important criterion when picking investment trusts.
Jim Wood-Smith is head of research at Hawksmoor Investment Management
