Taming a Risky Business

A margin loan can be magical, or it can be a curse from the depths of hell. They can help magically double, triple or quadruple your capital gains and dividends, or can help vaporise your dough in the blink of an eye. I’ve had a margin loan since mid-2001 and have been through all the ups and downs '” I’ve made small fortunes on some stocks using it, only to lose it all again on others. And I’ve been through all the human emotions: joy, desperation, denial, fear, triumph, and had innumerable sleepless nights.

Something had to change. Cancelling my margin loan is not an option because having experienced a margin loan’s magic, I know the power they have in multiplying your money. But the reality was that my ups and downs with my margin loan were not the fault of the margin loan, they were caused by how I handled it and the investment decisions I made using it. Finally last year I had an epiphany that has helped smooth out my margin loan rollercoaster ride, as well as allow me to multiply my capital gains and dividends '” I would only buy 75LR stocks with my margin loan.

"LR" is shorthand for "lending ratio". This is the percentage of money you can borrow on the value of shares of a particular stock. For instance, my margin lender has stocks with LRs from 40% to 75%, or "40LR" to "75LR". 40LR stocks tend to be small to medium caps, 50LR, 60LR and 70LR stocks are medium to large caps, and the 75LR stocks are the huge, mostly multinational companies.

In practice what the LR means is this that if you have $100,000 invested in a 40LR stock you can borrow $40,000 of that $100,000; with a 50LR stock you can borrow $50,000, and for a 75LR stock you can borrow $75,000 of the $100,000. To put it another way, for a 40LR stock you need $60,000 of your own capital to borrow a further $40,000; for a 75LR stock you need $25,000 of your own capital and to borrow $75,000 to make up the $100 000.

Of the roughly 400 stocks that my margin lender allows me to borrow against, only 18 are 75LR stocks. They are BHP Billiton, Rio Tinto and the four big banks '” CBA, NAB, ANZ and Westpac. They also include Macquarie Bank and St George, Coles and Woolworths, QBE, Westfield, Qantas, Foster's, PBL, Telstra, Woodside, and Wesfarmers.

The first thing you notice about all these stocks is that they are the biggest in the market and are extensively covered in the media. The next thing you notice is their diversity. There are the defensive stocks such as the big banks, Foster's, and Coles and Woolworths. There are cyclical stocks such as the diversified miners, Telstra and Wesfarmers. And there are representatives from the insurance sector (QBE), energy (Woodside), gaming and media (PBL), international retail property (Westfield), and transport (Qantas). In short, there is a stock for just about any mood on the market. And there’s even an entrepreneurial risk-taker '¦ahem '¦ investment bank '” Macquarie Bank.

My epiphany was that I would only use my margin loan to buy these 75LR stocks. The rationale behind it relates directly to the size of these companies, their profitability and cash flow, the coverage they get in the media, and their stability. But it is also inspired by a need to impose some structure and self-discipline on my use of the margin loan.

These companies are covered and reported on by all the market’s analysts and all the business media all the time. Theoretically, therefore, everything that a 75LR company does and all its inherent risks are well known to the market and there are very few unforeseen nasty surprises. There are exceptions, of course: Telstra, for example. But who could have foreseen one of its executives saying he would not recommend Telstra shares to his mother?

If the unforeseeable does happen and the stock’s price drops, the size and liquidity of these stocks mean that you can easily sell out. It also means that any downside is likely to be muted, probably short-lived, and probably could be considered merely a "buying opportunity". Whatever does happen though, it certainly will not be terminal to the company. At worst, you might just have to hold the stock longer than you planned to get you money back. Or you just average down, which is a safer strategy with these stocks too, especially since any share price reduction will merely increase their dividend yield.

NARROWED FOCUS

The increased personal discipline that comes from concentrating on 75LR stocks also limits the number of stocks I’m interested in. By virtually ignoring the 382 other stocks that I can borrow against, there are 382 fewer reasons why I won’t sell out of my 75LR stocks, and 382 fewer catalysts for me to potentially lose money.

But, the sharemarket is not rigid and neither is this strategy. Non-75LR stocks will come along that are under-valued and seem have promising potential for share price gains. But by focusing on the 18 75LR stocks, a non-75LR stock must have a compelling reason for it to be interesting.

At the moment those compelling stocks do exist. Some of those include ABC Learning (65LR), Billabong (70LR), and News Corporation (70LR) whose price seems to be recovering. On the contrarian side, the worst seems to be over for Multiplex (60LR), and AWB (70LR) at some point in the future will also hit bottom and will be a screaming buy. I note that at the beginning of March my margin lender kept AWB’s 70LR rating despite the scandal.

Yes, greed. And let’s face it, you wouldn’t have a margin loan trying to multiply your capital if you didn’t have it! And greed is where the real beauty of the 75LR strategy lies.

Using the above example of $25,000 of your own capital and $75,000 of your margin lender’s to buy $100 000 worth of shares, every 10% increase in the $100,000 results in a 40% increase in your own capital. The downside, however, is also extreme: for every 10% lost you lose 40%, and you can expect an apologetic margin call from your lender into the bargain.

You also have to consider interest and dividends. Your interest bill will make any 10% increase in share price and 75LR-multiplied capital gain a little less handsome but still pleasant, but paying interest on a 10% share price lose might tempt you to reach for the razor blades. On the plus side, if your 75LR stock also pays a handsome dividend yield '” for instance, Telstra or the banks '” your dividends on the total $100,000 investment might cancel out your interest costs and might leave you a little extra if you’re lucky.

The four-times multiplier-effect on capital gains and dividends of this 75LR strategy also makes 75LR stocks more appealing than investing in non-LR stocks, 40LR stocks, and even 70LR stocks. The 40% increase in capital gains with a 10% increase in share price lowers to a 33% return for a 70LR stock, 20% gain for a 50LR stock, and for a non-LR stock to a 10% gain.

Risk and return go hand-in-hand, and you won’t get a potential 40% return on a 10% stock price gain without running a risk of losing some or all your money, and receiving a margin call into the bargain. But you can mitigate these risks.

First, this 75LR strategy has mitigation built into it: you are only investing in Australia’s biggest, most well-known, theoretically most stable, and most liquid companies. Therefore, whatever bad news there is likely to be known and already priced into the stock, and whatever downside there is will be limited and might just be a "buying opportunity".

Second, stock selection. If you obey the basics of share investing '” buy low sell high, do not buy expensive (relatively high P/E) companies, do your research '” then any downside will be limited and upside maximised.

Third, don’t borrow at the maximum 75% lending ratio. This precaution increases the "comfort zone" before you hit the buffer and/or get a margin call, but it will also reduce the effectiveness of the four-times multiplying effect of a 75LR stock. Personally, I’m comfortable keeping my 75LR investments bumping up against the buffer, but that wouldn’t be something you’d do in a bear market or if you don’t have other shares that you can sell, just in case.

Investing in 75LR stocks that pay a high dividend yield also increase the strategy’s comfort zone through the dividend at least partially offsetting the interest on the loan. And finally, diversify '” don’t have all your capital in one 75LR stock. Have two or more 75LR stocks, or some non-LR stocks as well as the 75LR stock you’re invested in. This will allow you to cover any temporary embarrassment that arises, or give you access to an alternative source of funds to take advantage of any sudden buying opportunity in your 75LR stock.

I experienced this situation recently. BHP is my 75LR stock and I keep it bumping up against the buffer. In the recent resource stock’s correction it fell from about $26 to $24, or 7.5%, and went into buffer. I sold another underperforming stock to not only get BHP out of buffer but also to increase my holding '” at around $24, I increased my BHP holding by about one third.

WORKING THE MARGIN MAGIC

Keeping with BHP, let’s use it as an example of 75LR magic. Three years ago BHP was about $10. If you invested $100,000 then it would be worth about $250,000 now (at $25), not including dividends and capital returns. However, if you invested using a margin loan at the maximum 75LR, your original investment was only $25,000. So after paying $18,000 interest (at 8% a year) and paying back the bank you would have made $132,000 on a $25,000 investment, or a 528% return. Nice.

A year ago BHP was $16.50. If you bought at this price and using the same parameters, a $100,000 investment would now be worth $151,500. After interest, the return on the original $25,000 capital would be $45,500, or 182%. And six months ago BHP was about $20. Again using the same interest rate, a $25,000 investment in BHP shares at $20 using a $75,000 margin loan would return $22,000 or 88%. Not bad for six months "work"!

But that is historic. What about the future? Well, a number of large brokers have a 12-month target of $27 for BHP, and one has a target of $32. Assuming it takes a BHP shares a year to reach either of those targets, an investment of $100,000 at $25 a share and an interest rate of 8%, you would be looking at return of $2000 or 8%, or $22,000 or 88% respectively.

The lesson in these last two last examples is the difference the margin loan’s interest can make. To make any capital gain using your margin loan your investment needs to return greater than 6% '” the interest rate on $75,000 spread over the full $100,000 investment. Any capital gain above 6% is all profit, which explains the dramatic difference in capital gain between the $27 and $32 target prices; the $27 target is only 8% above the current price, but $32 is 28% higher.

Using BHP again, what if in a years time the bottom has fallen out of metal prices, BHP is thumped by the market and returns to $20 a share after you bought them at $25? A $100,000 investment is suddenly worth $80,000. Plus you must pay interest of $6000 on that accursed $75,000 loan that has multiplied your trouble, and the bank obviously wants its money back (and has pleasantly margin-called you a number of times to remind you). The result: suddenly there is nothing left of your $25,000, plus you have to pay an extra $1,000 in interest. And it being BHP, the dividends would not have helped your predicament much.

Or to use Telstra as an example, a year ago it was about $5; today it is about $3.80. Your $100,000 investment at $5 then would now be worth $76,000, so your original $25,000 capital would have disappeared plus you’d have to pay an extra $5,000 to cover the interest. You might have been lucky and the dividend yield covered the loan’s interest, but I bet you’d still wish you’d bought BHP a year ago!

Should you buy Telstra today using your margin loan? At $3.80 it is worth considering '” definitely!

First, T3 will happen. Too much political capital has been burnt for it not to happen, the Federal Government doesn’t seem too dogmatic on the sale price, and it has the Future Fund-dump as a backup for whatever T3 shares it can’t sell. Second, even the Government won’t sell a $25 billion asset that’s hog-tied, so the regulatory issues will probably be sorted out in Telstra’s favour and Telstra management knows it, which is why they are playing hard-ball.

Third, despite the brouhaha, the ACCC is largely irrelevant because if push comes to shove the coalition has control of both houses of parliament and can pass whatever legislation it likes.

Fourth, if T3 is sold using instalments and you invest $100,000 using your margin loan, the resulting 14% fully franked dividend yield on the instalments becomes a 56% (gasp!) fully franked dividend yield on your original $25,000 investment, which will just cover the 6% interest expense twice, with change (8% interest on $75,000 is 6% of $100,000). To get that 56% ... I mean those instalments '¦ you’ll need to fork out for a slab of Telstra shares beforehand, but the current 8% yield will easily cover your interest with change before the instalments kick in.

None of this takes into account any potential capital gains/loses, but how much lower can Telstra go?

If you then throw in simple facts like: one, T3 will be cheap; two, most super funds are underweight Telstra so will have to buy up big-time at some point sending the price northwards; and three, that a $50 billion market-capped Telstra with a stable Australian base will suddenly be off the leash.

To my mind, all that makes buying Telstra using your margin loan a no-brainer. My BHP holding is definitely looking increasingly short-term.

MICRO-CAP BEHAVIOUR

Something that is also important to realise is that having a margin loan even on 75LR stocks changes their nature and dynamics dramatically. They are no longer (theoretically) low-growth share price-stable stocks, but become market mood-sensitive beasts that can be volatile and unpredictable. A 1–2% rise or fall in their share price also becomes a 4–8% rise or fall in your holding. Plus you should be mindful of the interest rate you are paying: using the $100,000 example above, a 6% rise in your 75LR stock over the year is sending you backwards because it is only just paying your interest bill.

Given that increased volatility and the interest costs, you have to think about whether you should trade and take profits on your overvalued 75LR stock (especially after a 5–10% price appreciation), and buy another 75LR stock instead that is considered more undervalued. Sticking them in a bottom drawer will not necessarily use your margin loan to its full potential. You certainly should be more watchful and keep alternative 75LR stocks in mind.

Take the example of my BHP holding. When it hit $26 in early February the sentiment in the market seemed to be that there was going to be a correction. I was thinking about selling out when the correction hit, by which time it was too late to bale out. I held on, but that $2 share price drop made a dramatic (short-term) impact on my holding’s capital gain. Being a resource bull I bought more BHP at about $24, but if BHP hits $27 in the near term in the current environment I’ll consider taking some profits.

But then again '¦ in a year's time it could be $32 '¦

As a result of this strategy, my non-75LR stock holdings have become more and more biased towards micro-caps, so my portfolio has 75LR stocks and micro-caps with nothing in between. Why? Well, first, I generally can’t see the point in buying medium to large-cap stocks that aren’t 75LR since my returns on 75LR stocks have been so good. That point-of-view might change, but probably not given what I’ve just written about T3.

Second, holding a majority of my capital in 75LR stocks '” even with them maximum-geared and bumping against the buffer '” has given me confidence and a solid base to invest the rest of my capital from. Third, with the majority of my capital secured in 75LRs I’ve been looking for something equally adventurous.

I’ve largely avoided micro-cap resource stocks, though. I haven’t needed them when using my margin loan on BHP has given me micro-cap returns with the diversified miner’s unhedged exposure to iron ore, uranium, oil, copper, nickel, and even gold!

Micro-caps in Australia also tend to be undervalued because the media doesn’t cover them, and few analysts do. But they are an exciting, eclectic bunch, with companies involved in everything from Indian sandalwood production (TFS Corporation), oil and gas production (Stuart Petroleum and Petsec, among others) to global technology stocks (TZ Limited, QRSciences, ProMedicus and Datadot, among others). I particularly like the technology stocks. I’ll shed a bit of a tear when CiTech disappears for good from the ASX; it is a world-class technology stock that the Australian sharemarket totally undervalued and that we are therefore about to lose forever.

It doesn’t take much reading between the lines to know that I have an appetite for a little bit of risk. And a margin loan certainly isn’t risk-free, even if you don’t use them as aggressively as I do. But margin loans can also have an almost unbelievably magical ability to multiply your wealth. This 75LR strategy helps to mitigate the risks and makes me more disciplined about my margin loan investing.