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!