A virtuous circle

Been thinking a bit about investing and borrowing.Using a margin loan to buy shares, the shares bought are used as security for the loan. It’s much like buying a house – the house can be sold to pay off the loan. With a margin loan, the shares can be sold to pay off the debt.

Typically, margin loans are used at gearing levels that involve what I think is too high a level of risk. For example, at 70% gearing you would have some value of shares where 70% is paid for with borrowed money, and 30% with real money. Many margin loans allow gearing of 70% to 75% depending on the shares in the portfolio. Strangely, many lenders seem to encourage these crazy levels of gearing.
It can all come unstuck if there is a sudden fall in the market. The effect of a fall is the value of the shares drops, but the debt is the same. This means the gearing ratio goes up. Then you might get your friendly banker ringing with a “Margin Call” – which means you have 24 hrs to stump up the cash or they will start selling shares. Of course the sale is at the prevailing market rate – and if the market has fallen you are looking at taking some nasty losses.

It is much safer to keep the gearing ratio quite a bit lower – 30% to 40% is my threshold for a sufficient margin of safety (if you do the maths, about 35% gearing will let you survive about a 50% fall in the market).

There seem to be two common approaches to borrowing to buy a house to live in:

1. Pay off the loan as fast as you can to make it go away; and

2. Don’t bother to pay it off because the money is cheap.

All fair enough in their own way, depending on what your goals are and your degree of comfort with debt.

When it comes to investing, the same two approaches seem to apply.

In the first case, the idea is that you pay off the debt (if you took any on at all) and live off the earnings.

In the second case, the idea is that the asset appreciates in value at a sufficient rate that you don’t ever worry about the debt (essentially – the rate of growth of asset value is greater than the interest rate). Then, live off drawing down equity – ie make the debt bigger – when you want cash.

Here is another, though slightly more complex idea – mainly aimed at margin loans for shares. Just a new twist on an old idea.

Use debt as a source of funds for opportunistic buying, but keep it under control:

  • Buy shares in companies you have loads of faith in, when they have a scandal or fall on (short lived) bad times.
  • Pay some of the debt down from salary or earnings from the shares bought, so that there is more debt available the next time an opportunity comes up.
  • Aim in the long term to have a retirement fund that might have some associated debt – just not enough to worry about.
  • Keep the gearing ratio low.

The nice thing about this approach is that the incremental cash cost of using it is very small.

Time for a worked example: suppose I have no cash but I do have a some assets, and a margin loan with low gearing. Then I see Kick-ass Consolidated shares going for a good price, and giving (say) a dividend yield of about 5%.

If I have to use cash – tough – I lose because I don’t have any.

But if I buy using debt, I’ll pay about 8% interest on the borrowings. If I get a 5% dividend yield, fully franked, that is an equivalent interest rate of 7%. So the dividends are paying the debt for me, and the cost to me (to prevent the debt from rising) is the difference in interest rates: 1%.

This is a pretty neat deal: If I can buy an asset, and use the cash flow from the asset to pay the debt used to buy it, then I only have to make up the difference. If I can find that 1% of the purchase price, then paying the interest on the loan means you get the capital growth of the asset for 1% down. Potentially this is a very big return. I need to pay that 1% forever, though!

$10,000 purchase of Kick-ass Consolidated – all bought on debt.

Return is $500 per year + franking credits, effectively $700 per year.

Interest on the loan is $800 per year.

So to control $10,000 worth of Kick-ass, I only need to find $100 per year.

Now suppose that I can find (say) 20% of the cost price… lets use some numbers:

I buy $10,000 worth of kick-ass, using debt.

Results as before…

Now I get $2000 from Uncle Freddies inheritence, and pay that straight off the debt.

Return is still $700 per year.

Interest cost is now $8000 * 0.08 = $640 per year.

I can now do nothing and the asset will eventually pay off the debt entirely. Compound interest works in my favour, and the reduction in the loan gets faster each year.

Once the debt is reduced a little, I can go buy something else. The debt goes up, as does the income, and the first asset is helping pay for the second.

And so on, and so on…

Trouble with the above approach is that it is using a very high level of gearing (80%), so I’m at risk of a margin call if the price falls.

If instead you were to reverse the figures, ($2K debt, $8K cash) then the interest charges are well and truly covered, the likelihood of a margin call is dramatically reduced, and when you get the opportunity you have plenty of equity cover already in place to take advantage of opportunities that crop up.

Low to moderate gearing thus forms a low risk, cash-flow positive virtuous circle, where the more you own, the more cash you generate, so the more you can buy.

The kicker is that if you are very patient, and buy quality assets on bad news, you stand a better chance of getting some very nice capital growth thrown in as well.

And with the share market – time in the market is very important. The sooner you start, the better off you will be.

The thing that requires the greatest discipline is patience – it is far better to buy nothing, than to buy something that is too expensive.

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