In 1918, 22-year-old Walter Jacobs purchased 12 Ford Model-Ts and begin renting them to Chicagoans interested in a day or two of horseless carriage fun. Five years later, he sold the company to John D. Hertz, who, within two years, created the nationwide automobile rental industry.
A month ago, the 102-year-old company filed for bankruptcy, blaming COVID-19 for its inability to pay its bills.
The coronavirus didn’t kill Hertz. Poor capital allocation, evidenced by a whopping $18.7 billion in debt (and only $1 billion in cash), was the company’s downfall. The coronavirus merely exposed the company as a financial house of cards.
Debt, or financial leverage, is powerful. It is an algebraic magnifier, improving returns in good times, but intensifying any bumps in the road. More than 2,200 years ago, Greek mathematician Archimedes said that with a long enough lever he could move the world. Hertz executives overlooked what happens when you are on the short end of the lever: it takes very little to displace you.
A strong economy will mask a lot of problems and weaknesses. But recessions happen, and when companies (or people) build their lives on the assumption that things will always be rosy, the eventual recession that causes them to file for bankruptcy (or lose their car) is not their problem. Their problem is a cavalier or naïve attitude about risk – about leverage.
I am flabbergasted at the young adults I meet who operate with the same philosophy. They measure debt in terms of monthly payments, not principal amount. They finance a portion of their social lives on credit and borrow money to purchase assets with marginal or declining monetary value.
There is a difference between affluence and wealth. Webster’s defines “affluence” as “an abundance of property.” Anyone can amass an abundance of property if a bank or credit card company will loan them enough money. The only peace of mind that can possibly come from affluence is a fleeting sense of meaningless superiority over someone with a smaller boat or 10-year-old car.
True financial wealth, however, includes a measure of both assets and liabilities, as well as cash flow relative to fixed obligations. Two families with identical household income, living side-by-side in $1 million homes could have massive differences in wealth, simply based on each family’s debt. The family who spends more on shoes and expensive vacations might have a $5,000 monthly house payment, whereas the other family may have a much smaller payment – or even none at all.
On the surface, both families appear to be rich. But when COVID comes along and abruptly interrupts the income of both families, one of them is more likely to quickly find itself in panic mode – like Hertz.
Warren Buffett described this phenomenon perfectly decades ago when he wrote, “only when the tide goes out do you discover who’s been swimming naked.”
David Moon is president of Moon Capital Management. A version of this piece originally appeared in the USA TODAY NETWORK.