| |
| |
|
|
Stocks and Mutual Funds |
|
Leverage - Margin Debt
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.
MORE RESOURCES:
Google News |
|
|
|
RELATED ARTICLES
The Secret Method to Selecting a Winning Trading System Every successful trader has a winning system. There are of course, as many systems out there, as there are traders. How to Pick Winning Stocks There is nothing more exciting than finding an undervalued stock and seeing it explode out of nowhere rising in value 100% or more in a few weeks. Some stocks can move as much as 1000% in a year and?. Stocks Options Trading Let's assume that you want to make some serious money and you have chosen to take things into your own hands rather than depend upon a "professional trader" to make your trading decisions. This is usually only recomended if you can afford to lose the money that you are trading with, and you appreciate the fact that there is much more upside potential with this added risk. One Way Street Ever turn down a street, get half way and suddenly realize it is one way and you are going the wrong way? Is that the way you feel when you look at your stock brokerage statement?In either case don't panic. You can get out of that one way street by carefully backing out. Financial Crime Congress recently passed another new law that is supposed to outlaw financial crime. Corporate officers will be sent to jail for "cooking the books" as it is called. Struggling Stocks, Booming Commodities 04/28/2005NASDAQ dropped -12.5% year to date in 2005. Good Stock Market Tip; Good Return! Forget making a profit; instead focus on the income provided from your stock portfolio. That's right! Forget making a profit. Investing in the Stock Market - When To! Is really not as important as to how you invest in the stock market. And how you invest in the stock market should take into consideration what goals you are setting for that stock market investment. Stock Trading Secrets? How often have you come across an advertisement or e-mail proclaiming to "teach" you the stock trading secrets that Wall Street Insiders don't want you to know? Usually included in the descriptions of these trading products are claims such as "Make 10K monthly in minutes per day", or "Learn the secrets of Professional Stock Brokers", etc. etc. Seecrets on Investment: Tired of Making Huge Losses in the Stock Market - Part 2 Fundamental analysis.Fundamentals analysis says the best way to predict the future trends of a stock is to understand the financial figures of the underlying company. Lemmings Are Gathering Before they go over the cliff to their destruction these little furry ones get together for a party and celebration. Each tells the other how smart he has been with his investments and buying and selling of stocks and real estate. Which Way The Market I am hearing predictions by brokers, financial planners, talk show hosts and the talking heads on TV that the market is going back to its old highs - DOW 11,700 and NASDAQ 5000 here we come.It seems to me that in 2000 I heard these same people saying there was no top to the market and were looking into their crystal balls for DOW 30,000 or some other fantastic number. Social Insecurity Just about everything you have been told about Social Security is an obfuscation. That is a big word for convoluted truth or lie. Trading as a Business What can I expect to make my first year of trading?We get questions like this one quite often. We find that most aspiring traders don't have a clue as to what to expect from the market. Laws and Efficiencies and Theories of Diminishing Returns The basis of diminishing return discussions surround such simple notions; that when you have a very fast aircraft, you also have coefficients of drag issues. When you are building a quarter mile car and want to go faster you must realize that for every tenth of a second you need to lose 100 lbs. Long Term Financial Vehicles Investing in long-term financial vehicles give you the most gains but it also puts your funds at greater risk. There is much truth to the saying, "there is no gain if there is no risk". Trading Tips No 2: The Big Lie in the Stock Market It is commonly reported that the stock market averages about 10% per year return over the long term (decades). So the investor that buys and holds a diversified portfolio of stocks or mutual funds is led to believe that their portfolio will grow by 10% per year on average. Dont Buy Stocks based on P/E Ratio alone I use the P/E ratio as a secondary indicator for buying and selling stocks but I don't use the ratio in the same a manner as many value investors teach. I will explain the difference in my methodology for using the P/E ratio to your advantage. Paddle Your Canoe At some time in your life you have been on a river in a canoe and hopefully you had a paddle. You know about being up the creek without one. Analysts - Do They Really Know The Stock Market? When you become interested in a stock or mutual fund you can call your broker and he will send you reports on how the company is doing, what their management is like and what might be the projected earnings for the company and how the industry is doing. Great information.
|
||||||||||||||||||||||||
