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I used to tell my son that hitting a baseball correctly is all about balance. The same is true in investing; to invest correctly, you need to balance risk and return.

When I worked at Texaco, "protect the balance sheet" was our rallying cry. The goal was to never over-lever the balance sheet with debt, because a strong balance sheet would get you through the business cycles.

Now, when I teach, I harangue my graduate students over and over: Finance is a function of balancing risk and return. (Hopefully they can hold that thought after the semester ends!)

Kidding aside, I never cease to be amazed at how seldom people focus on the downside risk to their investments. Mesmerized by the allure of greater financial gains, people believe they can achieve high returns combined with low risk. In all my years in the business, I have yet to see that financial phenomenon occur.

In particular, investors time and time again fail to give ample weighting to "financial" or default risk arising from increasing leverage. Indeed, if you don't believe in credit risk, just look across the Atlantic at Europe, or remember Long-Term Capital Management or the housing collapse of 2008.

Leveraging your investment may magnify your returns as long as the investment heads north. However, if it turns sour, the higher interest expense will be harder to cover, and default may be knocking at your door. Excessive debt-whether public, company or individual-eventually reduces growth, and if left unchecked, will lead to bankruptcy.

In their recent seminal work, Professors Carmen M. Reinhart and Kenneth S. Rogoff warn of the danger of excessive public debt in two papers, "This Time Is Different: Eight Centuries of Financial Folly" and "Decade of Debt."

Essentially, both papers warn that public debt in advanced economies has risen to levels not seen since the end of World War II. They point out that high debt leverage levels have historically been associated with slower economic growth and higher rates of default or restructuring.

To avoid that fate, your investment portfolio should be filled with companies that have strong balance sheets and positive free cash flow to enable them to invest through the downturns. Conservative balance sheets insulate companies from economic slowdowns and reduce their financial risk, which in turn improves your investment portfolio risk-reward profile.

I recently took a look at the energy sector to find companies with strong balance sheets and positive cash flow after debt leverage service costs, and most importantly, strong production growth profiles. Companies I identified include:

• Suncor Energy (SU)
• Chart Industries (GTLS)
• National Oilwell Varco (NOV)
• Apache (APA)
• Energy Partners (EPL)
• Energy XXI (EXXI).

Leverage is and should always be a financing decision, not an investment decision.

So how do you use this information to improve your investment? First, ask yourself whether the investment has more upside gain potential than downside loss potential.

If it does, and you decide to make the investment, then decide how to finance it. If you believe financing makes a bad investment better, then you probably believe in a free lunch.

Editor's Note: This article was written by Lou Gagliardi of Cabot Wealth Advisory.

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This entry was posted on Wednesday, June 27th, 2012 at 10:05 am and is filed under MV News. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.

xavier