Phase 3 is characterized by high growth and rising leverage, as during the years 1997 to mid-2000. In this period M&A activity was rapidly accelerating, driven by a major focus on the creation of shareholder value. While earnings grew in this period, aggregate measures of corporate profitability like the ratio of after-tax profits of the nonfinancial corporate sector to GDP already declined. Deteriorating free cash flow measures also signaled heightened risk in the corporate sector. As one would generally expect in the expansion phase, equities performed well while credit spreads widened. In general, the high level of debt accumulated during the expansion makes companies vulnerable to economic downturns. Low growth and rising leverage increase the risk of defaults and rating downgrades, and are generally negative for credit as well as equity markets. The years 2000–02 are a typical example for this phase.

After the 1990/91 recession the US corporate sector underwent a period of massive restructuring. Balance sheet repair, rights issues to repay debt, asset disposals and measures to improve cash flow generation led not only to falling leverage, but also to low earnings growth rates. During this first phase of the debt–equity cycle, the ‘repair phase’ credit usually outperforms equities. It lays the foundation for higher growth rates due to an improved ability to generate cash flows. The subsequent recovery period is beneficial for equity markets as well as credit markets, as the years 1994–97 have shown.

Clearly credit and equity investors tend to look at the corporate sector from different angles. While the focus of equity markets is primarily on earnings growth, credit investors rely on debt-related factors to make their decisions. However, if one combines both perspectives the result is a stylized debt–equity cycle that may support both parties in the process of decision-making. The four phases of the cycle depend on the degree of earnings growth (high or low) and changes in leverage (rising or falling). Changes in leverage reflect the companies’ efforts to change their capital structure as well as their ability to generate cash flows. As an example we will examine the last complete debt–equity cycle that reached from 1991 to 2003.

Many investors try to avoid these troublesome relationships by using online brokers. Online investing is promoted as fun. Chat rooms, IPOs, after-hours trading, 24-hour research: The message is: meet interesting people and make quick, easy money. The results are not any better than using a live-body broker.

Studies show switching to low-commission, online brokers leads to overconfidence. Stocks are bought and sold online in seconds. Online research takes hours if done quickly, days and weeks if done properly. Online investors skip the research and go directly to the trading page. This causes excessive trading, which quickly adds up to excess commissions, large spreads, great unhappiness, and poor results. A few investors become addicted to trading.

Investors using online brokers often turn to chat rooms to get comfort during volatile markets. Chat rooms are full of investors trying to promote their own shares. Their agenda is to get you out of your shares and into theirs at ever-higher prices. Rumors and mass hysteria are treated as fact in chat rooms. Your gullibility will hurt you.

Cautious investors often place stop-loss orders on their account. These orders sell out your shares should they decline by the amount of pain you anticipate you are willing to endure. Stop-loss orders are supposed to make an unmanageable situation manageable. Brokers encourage this as stock fluctuations inevitably trigger sales creating more commissions and spreads.

In a market break, the sell point may be much lower than the level you specify. For example, on a surprising corporate announcement, it is common for prices to gap down by $10 or more. Your stop loss may have only been down $2, but you will be sold out at the next trade, $10 lower. Of course, you always have the opportunity to buy back in again for more commissions and increasingly wide spreads. Stop-loss orders often lead to anger and frustration as an attempt to bring order to an unmanageable situation fails for you, yet enriches your broker.

Brokerage accounts also offer you a “parking place” for your cash. These are sweep accounts: money market funds that collect dividends and the change leftover from trades. In the old days, dividend checks and change were sent to your home and you had the onerous task of depositing them in your checking account. The sweep accounts are marketed as a great convenience to you. In fact, they are a great convenience to your broker as they gather your funds within short distance of the trading desk. Again, particularly optimistic types should have the dividends sent home. Maybe there is only $1,000 at stake, but would you rather have a new couch to lie on during the bear market or would you prefer to whittle it away in commissions, spreads, and poor stock picks?

In every margin scenario, you may note, the broker collects larger commissions and more spreads than in a simple purchase-and-hold scenario. More shares are used in the transaction, plus the transaction inevitably involves a purchase, a sale, and margin interest.

Overconfidence in your investment ability is the main cause of margin investing. It is not a coincidence that the highest margin on record, $279 billion dollars, occurred at the peak of the NASDAQ in March 2000. Five years of 20 percent plus returns led investors to believe they could handle margin. Margin investing is best left to speculators or those with an admitted desire to lose their fortune. Optimists will be happier with a buy-andhold strategy. Even after the worst bear market, they will still own their stocks, assuming no bankruptcies, and have the opportunity to again hope for a great rise.

Comfort zone investing does not mean you become a flawless investor or a spiritual giant. For most people, striving for financial maturity is a process of self-discovery and self-acceptance, not a process of self-improvement.

To achieve serenity in investing, once you know how you relate to different investments, you do not have to change who you are; you simply need to change your investments to fit you. Often in marriage or work relationships, you must change yourself if you are to be happy, because your spouse or boss is not about to change. Changing yourself is much more difficult and painful than changing your investments.

Changing investments is not, however, entirely cost free. Switching from stocks to real estate, for example, incurs taxes, commissions, closing fees, research, and assessment hours, as well as other monetary, time, and effort costs. There are social costs as well. You may have to reach outside office norms to find what works for you. If you are a real estate guy and the firm only offers 401(k)s with no REIT option and lots of free company stock, you might have to explain to your colleagues why you put nothing in the plan and spend weekends driving around looking at shopping centers.

The best business plans tend to look like a truck ran them over. They are well-thumbed, heavily annotated, and popping their staples or bursting their bindings. That means they’re being used. The worst plans are clean, pristine documents that went straight from the printer into the file cabinet. That means they’re not being used. That may mean that nobody needs them, which might suggest that the company is continuing to follow the same old routes to get to the same destinations. Or it might mean the business plan isn’t worth the paper it’s printed on for those who should be following it. Either way, the company may be in serious trouble.

A business plan helps you achieve your goals. It also helps discipline the way you think about what you’re doing. But business plans have another important purpose.

Companies need business plans to apply for loans, grants, or other forms of funding to start or expand the business. Lenders and financial managers like to see something in writing that shows a firm is committed to its objectives and knows how it’s going to accomplish those objectives. Without a plan, serious outside funding—or any funding, for that matter— might not be available. After all, if you were in the business of investing money, how would you select the companies that would be the best risks?

But that means you need to write your business plan in different ways for different financial participants:

Plans used to attract equity investors—financial partners who will prosper as the business prospers—must be written to show how investors will gain from the company’s success. Investors expect a high rate of return, so they will be looking at growth and profit projections. Plans that project a successful profile are what equity investors are seeking.

Plans designed to appeal to lenders must demonstrate methodologies for repaying loans. At the risk of being simplistic, lenders have little financial stake in the success or failure of the company. They’re interested in how the company plans to repay the principle and its interest. And lenders are more likely than equity investors to be
concerned about cash flow. Your business plan should provide a timetable with repayment amounts the lenders believe your company will be able to make.

The business plan offers general and specific guidance on reaching company goals. It outlines actions. It also separates the dreamers from the doers. It is often the great equalizer between the enthusiastic idea generators and the serious business people who will accomplish their dreams.

Business plans are usually annual, based on the fiscal year. But there also are multiple-year plans—the most common of which is the five-year plan.

An annual plan is operational and necessary to manage the company’s economic needs for the coming year. A five-year plan is more strategic and designed to chart the firm’s direction. In addition, five-year plans should be rolling plans.

The thinking behind a rolling five-year plan can be applied to other cyclical planning, such as the annual budget process or the marketing schedule. When May ends, for example, the managers can study the forecasts for that month and the results, determine the reasons behind the variances, then use their findings to shape a budget for the following May. Rolling plans allow managers to make the most of their budget analyses, provide greater continuity, and ease the burden of annual planning.