The dirty “L” word – Leverage

Leverage 05052016

I have utilised leverage in my equity and bond portfolio in the past few 2 or so. Why is leverage a “dirty” word in investing? Several famous and esteemed investors have publicly advised against using leverage in investing:

Warren Buffett : “When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious,” explained Buffett in his 2010 shareholder letter. “But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”

Bill Ackman: “We don’t use margin leverage — never have and never will”

Howard Marks: “Leverage magnifies outcomes, but doesn’t add value”

I do note that all these investors have in 1 way or another, utilise leverage in one form or another. Every business utilises leverage.  A bank loan for equipment or working capital is a form of leverage. You hope to utilise a certain sum of money which is not yours, and grow it fast enough to return the loan and the associated interests, and still have a substantial bit left behind for yourself / the business.

All housing loans are a form of leverage. The owner hopes that rental + capital appreciation is > bank loan interest.

In the equity markets, all options are a form of leverage. You sacrifice the safety of your capital to buy a certain option, in the hope of getting magnified returns. After the time period of the option contract, the contract is has zero time premium. The holder hopes by then, the contract is in-the-money so that it can get exercised.

How did I utilise leverage?

In the local Sg context, there are limited ways to do so. I personally used a share margin account. After enquiring with several banks, Hong Leong Finance (HLF) gave me the best deal. (I have a relatively large credit line of up to $1mil, based on the pledged shares. I also have various business loans with them)

This is how it works:

I open a “sub-account” with HLF, and transfer all my shares from my CDP account into a custodian account held by HLF. Basically they hold my shares as collateral and have the right to sell if I default on the loan. So it is a secured loan afterall.

My broker then deals with HLF directly, of course after I have given permission to HLF, and given instructions to my broker. Each time I buy or sell shares, my broker deals with HLF. Every dollar sum is credited or debited from my account with HLF.

In turn, HLF grants me a credit line, which is based partly on the value of the shares I have pledged into the custodian account held by HLF. In my case, they offered $1.2mil, but I limited it to $1mil myself. In other words, I can buy shares of up to $1mil in value, and not pay a single cent for them. Kinda like a credit card.

Of course the capital is not free. HLF charges me a certain interest rate. What I like about this is the interest is “Real-time”. In other words, an effective interest rate, calculated on a daily basis. I only pay interest on the capital I have utilised, up to $1mil.

My experience

Here was my game plan. I figured that well, everyone who has made a lot of money, has to utilise leverage somehow, someway. I literally cannot think of anyone who has really created tremendous wealth without ANY form of leverage. No, I am not including people who inherit wealth.

So in this instance, the plan is to utilise capital that otherwise I wouldn’t have access to, generate a return above that of the interest, pay the bank the interest, and whatever is left behind is mine to keep. So the key question is, whats the interest?

When I first started, the interest was 2.85% for the 1st $500k, and 2.5% for anything above that.

Then it got raised to 3.25% for the 1st $500k, and 2.5% thereafter.

Then it got raised further to 3.45% for the 1st $500k, and 2.7% thereafter

Now, it is 3.6% for the 1st $500k, and 2.85% thereafter

now, the other nasty thing is, there are small fees involved on top of this. Quarterly maintenance fees, fees for dividend payouts, fees if you decide to transfer shares etc. Sure, they’re not a lot but it does add to the overall costs of utilising leverage.

I will add that these rates are definitely way better than what the rates are “normally” at that given point in time. I know this by comparing with other random investors who have contacted me to ask. They are better because of the relatively large quantum ($1mil), and the fact that I do have existing business loans with HLF. A little existing relationship does help.

At the initial interest, all I had to do was generate a return of >2.85% to turn “profitable”. Now my long term track record that I have been tracking, has been >10% easily. So this seems rather easy to me. Many equities give dividends above 2.85%, so this shouldn’t be tough. The interest is an effective interest rate too, which means that if I bought the shares just before dividend ex date, the interest would be way lesser than 2.85%/2.5% and I get to pocket “free” dividends.

And it worked.

Many of the equities I bought with the leveraged money not only gave higher dividends, they appreciated. The capital appreciation as well as the dividends was way more than the interest I had to pay, and I had a rapid growth in my funds.

Contrast that to now: an interest rate of 3.6% is no fun. Sure, there are still companies paying out more than that in dividends, but some of the companies that I have bought earlier have experienced capital depreciation instead, and the fall in prices (coincident with the rise in interest rates), have made such an endeavour non profitable instead.

At this stage, I’d bring up what I wrote earlier:

Warren Buffett : “When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious,” explained Buffett in his 2010 shareholder letter. “But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”

This is exactly what I experienced. It is very difficult to return to conservative practices after having utilised leverage successfully. The magnified returns are addictive. No doubt about that.

Still, I consider this to be a somewhat successful endeavour for me, as on the balance of things, it has still been profitable. Just less profitable than before.

The jury is still out on this though, as I am currently in the midst of deleveraging.

My conclusion

My view of the utilisation of leverage is that the party is over. The early adopters who have piled on leverage have earned the big bucks. Anyone trying to do this at this stage, is going to get burnt. The world is already highly leveraged, some countries actually have negative interest rates! It only pays to play in the game if you are early. As they say: the fools do at the end, what the smart guys do at the start.

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5 comments

  1. Just to add. Sometimes the problem with margin financing is not price dropping. It is the lender stop taking your shares as collateral and it can happen overnight.

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    1. That’s a good point.
      The shares I committed as collateral are taken at 100% of their value, but some counters (mainly small caps with large volatility) would have their value judged at a certain %, not 100%.
      Some others would not even make the list, meaning the bank does not accept it as collateral.

      I am not aware of any instances when the lender would overnight, suddenly reject the collateral which has previously been accepted

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  2. Hi, are you still using any leverage to invest? i was considering to use my margin account to invest however phillips poems gave me a 6% p.a. rate so it is too high for me to borrow.

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    1. Hi Yao Sheng
      I still have some leverage but have reduced it considerably, and am thinking of eliminating it totally for local equities.
      Reason being that the cost has risen considerably.
      Don’t use your poems margin account as leverage! 6% is just suicide. Not worth it.
      If you really want some leverage, if you have a very strong idea but am just lacking capital, go get a share financing account with any of the banks.
      The cost of capital used to be 2%+ per annum, pro rated.
      That’s very low cos most dividend yields are well in excess of that.
      Now, the cost of capital is around 4.5% for me for local equities, so I’m cutting it down completely.
      I still have leverage via margin from Interactive Brokers, for overseas equities or options.
      Those are much much lower.
      Regards TTI

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