What is leverage?
Here is a definition of leverage from an online dictionary
“leverage - The use of credit or borrowed funds to improve
one’s speculative capacity and increase the rate of return
from an investment, as in buying securities on margin.”
Essentially, the core idea of leverage is that investors can
use less money to control bigger amount of investment so
that investors can make more money when the price movement
is in investors’ favor. In fact, the investment involved in
leverage does not have to be stocks, it can be bonds, or
real estate, or any other investment vehicles. It does not
have be margin or debt either. Options (put or calls),
warrants are special kind of leverage where small amount of
dollar can control much bigger amount of common stocks.
Leverage is common tool available for individual investors.
Whenever we open a brokerage account at pretty much any
broker, such as E*trade, TD Waterhouse, etc, we can enable
margin or option feature pretty easily. Because options
usually are not favorable leverage tool for value
investors, I generally do not recommend options for
investment purposes. This article will focus mainly on
margin to illustrate the concept and usage of leverage in
stock investment.
Leverage - how it works?
Margin is open-ended debt that investors borrow money
forever as long as the margin requirements are met. Right
now at this low interest rate environment, brokerages
typically charge about 5% - 7% interest rate on margin
debt.
Here is an example how an investor can make more money by
using margin. Suppose John had $10,000 deposited into a new
brokerage margin account 5 years ago. Margin interest rate
was 5% for past 5 years. John has invested into only one
stock XYZ with 20% yearly smooth performance( there was
rarely such stock existing, just a hypothetical one) for
past 5 years.
Case 1
If John did not use any margin and fully invested that cash
into stock XYZ, the past 5 years performance was 20% per
year or 149% total performance for 5 years as in Table 1.
Table 1 Full investment into XYZ, no margin.
year Account Equity Value
start $10,000
year1 $12,000
year2 $14,400
year3 $17,280
year4 $20,736
year5 $24,883
Case 2 If John invested $20,000 into XYZ in his account and
borrowed $10,000 money on margin 5 years ago, every year
John had to pay 5% interest or $500 margin interest, but the
investment performance was 30% per year or 273% total
performance for 5 years as in Table 2. That is significantly
higher performance than Table 1 case.
Table 2 Borrowed $10,000 on margin. 5% margin interest
year Account Equity Value
start $10,000
year1 $13,500
year2 $17,800
year3 $23,060
year4 $29,472
year5 $37,266
Leverage - are there any trap?
By looking at table 1 and table 2 cases, should we all rush
into margin tomorrow? Not yet. There is serious flaw in
above 2 cases.
In real life, you can rarely find a stock performed like
above example XYZ! In fact, investors should never expect a
stock can rise smoothly over relatively long time frame.
Here is a typical stock XYZ would have done for 5 years. The
5 years performance was still 20% per year in average, but
not smoothly. In the beginning of second year, due to a
short term negative event, XYZ lost 60% of price suddenly
and recovered all losses and gained 20% that year at year end.
Now let’s redo that math for above cases.
Case 1 If John did not use any margin, the 5 year
performance was no difference. John did not sell during the
second year 60% loss and he still made 20% for that year.
revised Table 1 Full investment into XYZ, no margin.
year Account Equity Value
start $10,000
year1 $12,000
year2 $14,400
year3 $17,280
year4 $20,736
year5 $24,883
Case 2 If John invested $20,000 into XYZ and borrowed
$10,000 money on margin 5 years ago into that portfolio,
The beginning of second year John had $24,000 in XYZ with
roughly $10,500 margin on it. Because XYZ lost 60% suddenly
during that year, which triggered margin call, John’s
broker liquidated John’s account and John lost everything on
year2! John’s account was wiped out
revised Table 2 Borrowed $10,000 on margin. 5% margin
interest
Account Equity Value
start $10,000
year1 $13,500
year2 $0
year3 $0
year4 $0
year5 $0
Let’s think about above revised tables. XYZ stock was not really
bad stock, it performed well with 20% return over past 5
years. However, by misusing margin, John actually lost
everything and got wiped out!
Don’t use leverage, don’t use margin if you do not fully
understand it!
Rule No. 1 - Forget about reward, focus on safety
The No.1 reason investors want to use leverage is to make
more money, not to lose money. Wipe out is especially bad.
Over past decades of stock investment, I made lots of
mistakes before, speculation and losses at earlier years,
misjudgment of stock analysis, etc. But one thing I never
encountered that I never got wiped out because I have always
been aware of the danger of margin and danger of leverage
lure.
I have seen online BBS discussions that somehow wipe out is
beneficial to investor and a great investor must go through
multiple wipe outs. Maybe one wipe out was not that bad for
an individual so that he/she can learn a lesson in earlier
years. Something must be wrong if the investor went through
multiple wipe outs. He/she was not learning from past
failures.
The risk of margin comes from the volatility of stocks and
diversification degree of portfolio. To avoid risk of margin
leverage, investors can study past chart of stock price, and
diversify portfolio into different stocks or different
industries. While a value investor does not have to care
that much about short term stock price movement, a value
investor must take extraordinary caution on analyzing the
volatility of a stock if he/she is using leverage in stock
investment.
While past stock price volatility and portfolio
diversification are all relevant, there is more to consider
on leverage. Here comes Rule No.2 below.
Rule No. 2 - the riskier the investment, the less the
leverage
The key thing to avoid wipe out in leveraged investment is
to use leverage based on risk of investment. The more risk
of portfolio, the less leverage or less margin can be used.
The risk can not just be past volatility, a value investor
must do home work of business analysis of company profits or
earnings to assess the risk of investment.
Real estate is relative safe so that homeowners or real
estate investors can use 4-1 to 10-1 leverage to buy a
house on mortgage.
Banks use up to 100-1 leverage and most local banks in USA are
pretty safe. Bank business is essentially like a leveraged
investment. Banks borrow money from retail depositors and
lend out money with mortgage or business loans. We can
consider mortgages or business loans are “investment
vehicle” of banks. The interest difference between checking
account (0%-1%), or CD (2%-3%) and mortgage or business
loans (5% to 8% or more) is what banks are making. Because
interest rate up or down volatility is not as big as that of
stocks, 100-1 leverage is not really as scary as it may
appear in many cases.
Value investing is just a “special” kind of business just
like bank business or real estate investing. Value investors
can evaluate leverage usage just like a bank or real
estate investor. There is nothing truly wrong with leverage
if investors can properly use it. The value investor master
Benjamin Graham said clearly in his book Intelligent
Investor, that it is perfectly OK to use margin to profit
from some bond arbitrage opportunities while it is actually
very unwise to load full bunch of hyped up penny stocks in a
cash account!
Rule No 3 - Look for minimum 2-1 margin interest coverage
In typical security analysis, an interest coverage of 4-1 or
2-1 minimum ratio is usually standard criteria to assess the
risk of bond investment. If a company’s pretax or
pre-interest earning is $4 per share, and its debt interest
is $1 per share, it meets the 4-1 interest coverage ($4
divided by $1) and therefore the company’s bond is
considered as safe investment.
The same concept can be applied to leveraged value
investment. This is particularly true for certain bond-like
investment like REIT or high dividend stocks. If the
investment reward is less than 2-1 ratio, don’t even
consider to use any leverage.
Case study on FB Here is case study of my past 2001 stock
pick Friedman, Ramsey Asset (Ticker FB, now merged into
FBR). In 2001, FB was trading right at its book value with
18% dividend yield, and it was REIT stock. Its business
model was leveraged mortgage investment by borrowing short
term loans with 3% and investing into long term Fannie Mae
or Freddie Mac mortgage with interest of 5%. FB utilized
10-1 leverage on this 2% interest rate spread and made
nearly 20% return to support this 18% dividend yield.
FB business risk is mainly from interest rate risk. Because
the mortgage was guaranteed by a quasi-government company
Fannie Mae or Freddie Mak, there was little credit risk
involved in FB business model. In fact, compared to banks’
sometimes 100-1 leverage ratio, FB business leverage was
pretty low and reasonable. After an internet bubble, I
predicted that interest rate would be quite stable
if not lower. The stock volatility was not issue as well. If
FB stock price dropped below book value too much, FB company
and its affiliate FBR would simply buy up its common shares
instead of investing into mortgages.
Considering 18% dividend yield vs 5% brokerage margin
interest, there was nearly 4-1 ratio of margin interest
coverage if I use margin to buy FB stock, which was exactly
what I did in 2001. During 2001, 2002 and 2003, FB was very
solid stock delivering 18% dividend yield. After the merger
with FBR, FB+FBR almost doubled from where they were couple
of years ago.
Of course, FB investment was just one position of my
diversified portfolio together with NEN and other stocks.
But the rule of 2-1 minimum margin interest coverage can be
applied to other positions as well.
Certainly with portfolio full of safe stocks like FB, or
NEN or other similar value stocks, using a small amount of
margin made sense to enhance performance back in 2001 even
though the market was horrible then. If the stock was a tech
stock like CSCO or YHOO, margin would have been disastrous
and sure way to wipe out an account.
Currently with 7% dividend yield and rising interest rate
outlook, FBR is no longer as safe and profitable investment
as FB was in 2001. FBR no longer qualifies my margin
interest coverage requirement today.
OK, that’s all for today, remember Don’t use leverage until
you fully understand it!
Article by Henry Lu of BlastInvest LLC, a premium investment newsletter publisher in Connecticut. Visit http://www.BlastInvest.com for FREE “how-to” investing assistance, web services and more.