Other People’s Money: The Power of Leverage

In the wake of early February’s stock market swoons, Wall Street is casting a wary eye at leverage. There’s growing concern about mounting corporate debt, spiking U.S. Treasury yields, and ballooning federal budget deficits.

Non-financial corporate leverage in the U.S. is at its highest level, relative to gross domestic product (GDP), since before the Great Financial Crisis of 2008. The latest data show that this U.S. corporate debt stands at $8.7 trillion, or more than 45% of GDP. Analysts are worried that history is on the verge of repeating.

Leverage is just a fancy word for “debt.” We’re conditioned to think of debt as necessarily bad, but that’s a simplistic view. If used correctly, leverage can be the friend of individual investors.

Here, I’ll examine a few common and simple ways that you can use leverage to turbocharge your returns.

Through the strategic deployment of leverage, you can give your portfolio a shot of steroids, for exponential gains in relatively short time frames.

Margin loans, futures contracts and options are just a few of the widely used means by which investors can take advantage of leverage in their portfolios.

The more you apply leverage, the greater your returns can be. But the losses can be greater as well. Leveraging your investment makes the returns more volatile. It’s not for risk-averse investors, nor the inexperienced.

Warren Buffett put it best:

“When you combine ignorance and leverage, you get some pretty interesting results.”

To be sure, there are clear benefits to owning something outright. For example, stock ownership conveys to the stockholder an actual share of the company, certain voting rights (depending on the stock) and, if available, dividends.

On the other hand, without using leverage, you’re limiting your potential gain from an investment.

Leverage can be used at the individual level (we’ll talk more about that later), but a good way to harness the power of debt without going into debt yourself is to buy a stock of a company that uses leverage at the corporate level. Corporate leverage is a powerful driver because it directly multiplies the corporate earnings of the company, which in turn drives stock prices.

When a company uses debt, more of its top line revenue growth flows through to its bottom line earnings number. And when you break down stock investing to its essence, a stock’s value is solely dependent on the present value of the future earnings that will be generated by the company.

Leveraging the Midas Metal…

A good way to illustrate the gain-boosting power of corporate debt is to examine the difference between owning gold and owning gold mining stocks.

An investor who buys gold outright owns an asset that will fluctuate in value. If you buy an ounce of gold at $1,000 and the price goes up to $1,100, you’ve just captured a +10% return.

Not too bad. And chances are good the price of your asset won’t fall all the way to zero, so the limited upside you’re exposed to is balanced out by the limited downside risk. Non-leveraged positions are inherently conservative.

But if you own gold mining stocks and the price of gold goes up, the notion of “operating leverage” comes into effect. A bump in gold prices will likely exert an exponentially huge boost on a gold producer’s top line revenue. And because the producer doesn’t have to put a whole lot of additional labor or capital into digging out increasingly valuable gold, its earnings per share should go up and take the stock’s share price with it.

At +10% increase in the price of gold should eventually lead to a more extreme price movement in the price of gold mining stocks because the gold miners have debt on their balance sheets.

Of course, the only rational reason to invest in gold stocks is if you have determined that the actual price of gold will rise — and our investment strategists think it will.

Using loans and lines of credit…

The simplest and easiest form of investment leverage is through a loan or a line of credit.

To better understand how leverage amplifies returns, consider a common form of leverage: the home mortgage.

Here’s a hypothetical return calculation: You decide to buy a $100,000 house with a $10,000 down payment and a $90,000 mortgage. The $10,000 is your equity investment in the home, and the rest of the purchase price is covered by the bank’s $90,000.

If the home’s value increases to $110,000, you’re able to pay back the $90,000 bank loan and keep the remaining $20,000. You made a +100% return on your $10,000 investment.

Had you purchased the house with 100% cash, you would have made $10,000 on your $100,000 investment, a return of only 10%.  [The rate of return calculation is ($110,000 – $100,000) / ($100,000) = 10%]

Getting back to stocks, let’s say you have a hot tip on a stock you’re convinced will move dramatically upwards in a short amount of time. You could borrow the money to buy the stock, sell the stock before the loan is due, and pocket the profits (assuming the stock has gone up).

As a rule, stockbrokers enforce a “no credit card” policy for buying stocks, to protect average investors from getting in over their heads. But that only applies to direct card purchases. There is nothing to prevent you from using a line of credit or cash advance from your credit card to buy stocks. That being said, you have to make sure that the return on your investment exceeds the interest and transaction fees incurred by borrowing the money.

The advantage of using “plastic” as investment leverage: credit card debt is unsecured and poses no danger to your assets. The disadvantages…well, they’re obvious. You could be very wrong about your hunch and get stuck with a lousy investment, as well as a big fat credit card bill.

Buying on margin…

Most brokers will let you set up a margin account, which allows you to borrow money from the broker at a pre-set interest rate. Investors can generally borrow up to 50% of the cost to purchase stocks.

Let’s assume you have $10,000 to invest and you use it to buy 500 shares of a $20 stock. If the stock’s price goes up to $25 in 12 months, you end up with a $2,500 gain and a +25% return. That’s your un-levered return.

Now, let’s apply some leverage and see what happens.

Assume you still have $10,000 to invest, but your broker allows you to borrow up to 50% of any stock purchase at an interest rate of 10%.

Now you can buy 1,000 shares at $20 per share, for a total investment of $20,000 ($10,000 borrowed and $10,000 cash). The stock goes up to $25 per share and you cash out your shares for $25,000. You pay back $10,000 to your broker, plus $1,000 in interest. The $4,000 profit on your $10,000 investment is a whopping +40% return.

One of the worst things that can happen to an investor is receiving the dreaded margin call from his or her broker. A margin call is a brokerage firm’s demand that a client deposit cash into their account to bring the account balance up to the minimum maintenance margin requirement.

Investors must put up a minimum initial margin of 50%, a rule enforced by the Federal Reserve. Furthermore, a “maintenance margin” of at least 25% must always be maintained. The maintenance margin protects the broker if the value of your investment declines.

If your “equity” in value of your securities drops below the maintenance margin of 25%, your broker will send you a notice (a “margin call”) that requires you to either liquidate your position or inject more cash into your account.

I’ll examine other forms of leverage, in future issues.

Questions about leverage? Shoot me a letter:

John Persinos is managing editor of Personal Finance and chief investment strategist of Breakthrough Tech Profits.

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