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. Or they can stretch the minds of the finest quantum mechanics. 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 match the concept of the accelerator to a company’s sales, the gearing ratio tells us what should be happening to the output - the 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% 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 on 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 and everything to borrow beyond their eyeballs in the last decade in the belief that there would be no return to boom and bust. Without any bad times ahead, infinite gearing was the future.
Coming back to our 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 to have 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 they can go faster. Again there is sound mathematical logic. If the market rises 10%, then a portfolio might also rise 10%. If the fund were 100% geared, then the value would rise (before finance costs) by 20%. Easy peasy.
If markets rise, then surely the higher the gearing the better? Yes and no. Markets, like economies, fluctuate. Gearing can be like flying at full sail, wonderful with the wind behind but not great when you’re trying to go 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. Gearing is an important level of complication in picking investment trusts.