Can We Talk About Leverage?

[undervalued]

Invert, always invert: Turn a situation or problem upside down. Look at it backward. What happens if all our plans go wrong? Where don’t we want to go, and how do you get there? Instead of looking for success, make a list of how to fail instead – through sloth, envy, resentment, self-pity, entitlement, all the mental habits of self-defeat. Avoid these qualities and you will succeed. Tell me where I’m going to die, that is, so I don’t go there.  - Charlie Munger

 

Leverage is one of those things that can kill a business/portfolio.

 

True.  But so can other things.  Leverage is just a risk among risks.  Most should avoid it, but then again most should avoid direct stock selection and go through indexes.

 

Thought experiment:

 

Which of the following is riskier:

 

1.)  A ten stock portfolio, equal sized, made up of whatever the current ten most recently discussed names on the "Investment Ideas" section.

 

or

 

2.)  An investment in the S&P 500 index where one buys $115 for every $100, borrowing the $15 on margin. (Margin for decent sized accounts today costs less than 1%.)

 

This is too obvious.. Because #1, you really don't know what you're investing in where as #2 already has track records. I think for #1, we should be able to pick a ten stock portfolio, equal size and made up of any discussed names on the "Investment Ideas" section. Because more than 90% of hedge funds can't beat even beat S&P over long period of times and they can pick whatever they want.

[HJ]

My experience has been that people who are destroyed by leverage rarely realize it was the leverage that did them it.  To them it was always some "other" external factor that was an issue, and if it weren't for that factor things would have been fine.

 

Isn't it also true that lots of people attribute their success to their business acumen and operating expertise, when leverage is an integral part of their success? (Read private equity shops, commercial real estate developers, cable company operators?)

[philippoc93]

Invert, always invert: Turn a situation or problem upside down. Look at it backward. What happens if all our plans go wrong? Where don’t we want to go, and how do you get there? Instead of looking for success, make a list of how to fail instead – through sloth, envy, resentment, self-pity, entitlement, all the mental habits of self-defeat. Avoid these qualities and you will succeed. Tell me where I’m going to die, that is, so I don’t go there.  - Charlie Munger

 

Leverage is one of those things that can kill a business/portfolio.

 

Undervalued,

 

Not one to knit pick, particularly when this thread seems to not have been stirred in a while, but the above quote might be a little inappropriate (unfortunate) in this particular instance:

 

“And he was willing to borrow money to make money, whereas Buffett had never borrowed a significant sum in his life. “I need three million dollars,” Munger would say, on one of his frequent visits to the Union Bank of California. “Sign here,” the bank would reply.25 With these huge sums, Munger did enormous trades like British Columbia Power, which was selling at around $19 and being taken over by the Canadian government at a little more than $22. Munger put not just his whole partnership, but all the money he had, and all that he could borrow into an arbitrage on this single stock26—but only because there was almost no chance that this deal would fall apart. When the transaction went through, the deal paid off handsomely.”

 

Its from the snowball effect by Schroeder

 

I don't have the exact quote Munger made (I think it's the baseball pitch analogy), but I believe that it was along the lines of - when odds are and risk/reward (expected value) is incredibly in your favour, it's time to bet big. I think this is the time to use leverage. Now I can't offer any practical experience, because I have never used leverage in my long and prestiged 4 month investment career. However, I'm starting to absorb as much about options, non recourse leverage as I can now, so I'm ready to pounce when there is blood in the streets.

 

I wouldn't be touching leverage now at such elevated valuations. Was considering it for some of the oil plays, but then thought that was a stupid move as they are already a massively levered play.

 

My thoughts got ahead of me there so I'll stop now.

 

Lovely to make your acquaintance everyone and I look forward to great discussion with you all.

 

Phil

[scorpioncapital]

That's an interesting arbitrage spread. 14%. In today's environment, a spread like that would imply a real risk of the deal not closing. Look at AGN/PFE which had a 20% spread just before blowing up. If you had leveraged up 3:1 or higher on that you've lost 2/3 of your money. But of course the matter here is analyzing the situation. I suspect, however, that spreads were higher in those days - as were interest rates and inflation.

[james22]

I think the time to use leverage is when there is a fairly clear point of maximum pessimism in the market, i.e., some clear inefficiency or irrationality you can point to to explain why bargains are present.  Also, most of my margin went to buying BRK stock when it was close to book value, something I thought was a no-brainer.

 

I can borrow a year's base salary from my employer at 3%.

 

The market crashes and BRK falls with it to BV (or below), I'll take advantage of it.

[tede02]

An overlooked source of leverage for most individuals is a 401k loan.  The amount you can borrow is usually limited but you pay yourself back the interest.  Haven't done it myself, but I keep it in the back of my mind for the rare opportunity when (or if) I find an extremely high probably investment. 

[ERICOPOLY]

An overlooked source of leverage for most individuals is a 401k loan.  The amount you can borrow is usually limited but you pay yourself back the interest.  Haven't done it myself, but I keep it in the back of my mind for the rare opportunity when (or if) I find an extremely high probably investment.

 

Non-hardship loans against your 401(k) must be repaid within 5 years if you stay with your employer.

 

But if you leave the company before the 5 years are up, the loan must be repaid within 2 months of your departure.

 

After 2 months, any outstanding loan balance (minus any nondeductible contributions) is treated as taxable income. In addition, if you're under the age of 59½, you'll also have to pay an additional 10% early withdrawal penalty on the outstanding loan balance. Ouch!

 

https://ttlc.intuit.com/questions/1899463-what-happens-if-i-have-a-401-k-loan-but-later-lose-or-quit-my-job

[tede02]

Eric brings up a good point.  Make sure you understand the rules and plan accordingly. 

[SharperDingaan]

When you leverage you simply increase risk - the higher highs, lower lows, more volatility, etc. ... but almost nobody want to recognize that risk is simply just a part of life.

 

Your choice of spouse was a leveraged bet on long-term happiness. The decision to have kids, buy a house, type of car, choice of degree, etc., etc., etc. ...were additional leveraged bets  You knew going in that sometimes it works, & sometimes it doesn't; and that the greater loss was in 'not stepping up to the plate'. You benefited - because you recognized that risk is part of life.

 

Investment is no different.

 

SD

[KCLarkin]

When you leverage you simply increase risk - the higher highs, lower lows, more volatility, etc. ... but almost nobody want to recognize that risk is simply just a part of life.

 

This might be true if there was a source of perpetual, costless, non-callable leverage. But the leverage available to retail investors tends to convert temporary volatility into permanent loss of capital.

 

There is also a psychological and practical asymmetry between gains and losses. "Never risk what you have and need for what we don’t have and don’t need.” – Warren Buffett

[Guest longinvestor]

When you leverage you simply increase risk - the higher highs, lower lows, more volatility, etc. ... but almost nobody want to recognize that risk is simply just a part of life.

 

This might be true if there was a source of perpetual, costless, non-callable leverage. But the leverage available to retail investors tends to convert temporary volatility into permanent loss of capital.

 

There is also a psychological and practical asymmetry between gains and losses. "Never risk what you have and need for what we don’t have and don’t need.” – Warren Buffett

 

Love the phrase "convert temporary volatility into permanent loss of capital". It seems to me that the asymmetry of information is stacked against the retail investor. I'ven noticed weird trading around options expiration dates in stocks I've held.

[BG2008]

Value investing is a "single edge form of leverage"

 

For Example:

 

An asset cost $100, you borrow $50 and you put $50 of equity. 

 

When you buy a stock/company at 50 cents on the dollar, you are only putting up $50 of equity because someone less intelligent or less patient than you decided to sell it to you for $50 for something that's worth $100.  Net net, you have $100 of exposure that you only paid $50 for.  Without a lender's involvement, you benefit from the upside of that leverage without the downside of having your loan called away at the wrong time. 

 

I like to keep my investing simple.  If you can't find value, don't try to juice it by borrowing against it.  There's been times where I've thought about borrowing money from relatives at 4-8% APR for 3+ year terms where the aunt/uncle can't force a return of that capital during a 08/09 scenario.  They can't trigger a call because the stock price fell.  Frankly, I'll be borrowing against my reputation not with margin against my stocks. 

 

If one must engage in leverage, there's an amount that's obviously stupid and reckless and there's an amount that's obviously fair (105% exposure).  Finding the transition point is hard. 

[jmp8822]

An overlooked source of leverage for most individuals is a 401k loan.  The amount you can borrow is usually limited but you pay yourself back the interest.  Haven't done it myself, but I keep it in the back of my mind for the rare opportunity when (or if) I find an extremely high probably investment.

 

Also, don't forget if you have a pretax account, and the interest rate is say 6%, there is a tax disadvantage on the interest. The 6% you pay back is after tax money, which then if taxed again when you withdraw it later. This would be very expensive if you are in the top bracket, whereas other loans might have an interest deduction in the first place, rather than double taxation on the interest.

[randomep]

An overlooked source of leverage for most individuals is a 401k loan.  The amount you can borrow is usually limited but you pay yourself back the interest.  Haven't done it myself, but I keep it in the back of my mind for the rare opportunity when (or if) I find an extremely high probably investment.

 

huh????

 

The purpose of leverage is to increase your balance sheet so you can make more income. But borrowing from your 401k is moving it from one place in your balance sheet to another?  And of course there is the double taxation issue.

 

The only advantage to borrowing from 401k is to invest in things you cannot invest in your 401k. But there is just such a high cost.

 

 

[nodnub]

I think the time to use leverage is when there is a fairly clear point of maximum pessimism in the market, i.e., some clear inefficiency or irrationality you can point to to explain why bargains are present.  Also, most of my margin went to buying BRK stock when it was close to book value, something I thought was a no-brainer.

 

I can borrow a year's base salary from my employer at 3%.

 

The market crashes and BRK falls with it to BV (or below), I'll take advantage of it.

 

At the point of maximum pessimism strange things are usually happening.  Do you know anyone at your company that was able to initiate a draw on this loan in early 2009?  The reason I ask is that a lot of companies had money in commercial paper that suddenly they couldnt cash in.. leading to liquidity problems and inability to meet commitment to perks like employee loans.  Some people had access to Home Equity LOC suddenly frozen during the 2009 crisis.    All I'm saying is be careful about what you count on as a source of liquidity during a true crisis.

[randomep]

 

 

I would think for the average person the best thing to do is have a HELOC ready and use it in the event of a crash to go on a shopping spree.

[DavidVY]

How about using IB low interest margin to lever up with stable consumer stocks paying 2.5%+ dividend.

 

Buffett did it w/float (low coast interest margin). We can do it today because of central bank stupidity.

[LC]

How about using IB low interest margin to lever up with stable consumer stocks paying 2.5%+ dividend.

 

Buffett did it w/float (low coast interest margin). We can do it today because of central bank stupidity.

Not a bad idea IMHO. Are you following through on this?

[fareastwarriors]

 

 

I would think for the average person the best thing to do is have a HELOC ready and use it in the event of a crash to go on a shopping spree.

 

Too bad my HELOC is tapped already to buy another bubbly asset, a house.

[tede02]

An overlooked source of leverage for most individuals is a 401k loan.  The amount you can borrow is usually limited but you pay yourself back the interest.  Haven't done it myself, but I keep it in the back of my mind for the rare opportunity when (or if) I find an extremely high probably investment.

 

huh????

 

The purpose of leverage is to increase your balance sheet so you can make more income. But borrowing from your 401k is moving it from one place in your balance sheet to another?  And of course there is the double taxation issue.

 

The only advantage to borrowing from 401k is to invest in things you cannot invest in your 401k. But there is just such a high cost.

 

This is not accurate.  When you borrow from a 401k, you are not withdrawing money from your account.  The 401k plan is issuing you a loan and in-effect, your 401k holdings are the collateral. 

 

Also of note, some plans do not allow for loans.  It's up to the business owner when they establish the plan. 

[DavidVY]

How about using IB low interest margin to lever up with stable consumer stocks paying 2.5%+ dividend.

 

Buffett did it w/float (low coast interest margin). We can do it today because of central bank stupidity.

Not a bad idea IMHO. Are you following through on this?

 

Yes, diversified industries.

- Nestle

- Diageo

- Health/Life Insurance with divies

- REITs

- High yield bonds (3yr duration)

- Asset-light high FCF- biz : Amdox

- Berkshire

- Google (before the surge. I backed out cash. It was selling at 26 PE @ the time, but backing out cash, closer to 16 PE. Mkt multiple for a company gaining operational leverage and compounding 10%+. Easy decision).

 

Diversification becomes more and more important when you have leverage.

 

Currently 175% long on not a very big sum (<100k). Salary can bail me out if things go sideways in the next year or so.

 

I don't think central bank liquidity will dry up in the next 3-5 years, but I will have to re-evaluate as the position grow into the leverage (leverage will naturally reduce).

 

Its also great as negative gearing. I try to max out my losses/margin interest to defer income from this year to next year EACH year. Basically try to get around 3k deduction every year.

 

I have a high income bracket so its a great structural advantage.

 

Buffet is a master of tax-code. There is a lot we can learn from him about defered tax liabilities. I think thats why he never sold Coke in the 90s. 

 

Its very seldom that you should switch from a "compounder" if you have embedded tax hits.

 

The take-away is hold all your great positions until they become "obscenely overvalued" if they have large cap gains. I'd say to sell when earnings yield of compounders become less than treasury yields. Coke was at one time selling at a normalized earning yield lower than treasury yields (4-5%).

[LC]

Very cool post. Thanks for sharing your strategy...

[scorpioncapital]

Keep in mind that there is pass-through debt. Many of these "stable" companies you leverage 2:1 are in turn leveraged 1.5 or 2 to 1 or more. So your leverage is really astronomical. I prefer to take the leverage at the corporate level as they can lock in a long-term low rate. Your IB rate may go up any time. Likewise, even stable stocks can drop 20 to 25% in a recession - depending on their own leverage ratios. I would add an extra 2 conditions. 1) That the stable company you buy is not excessively leveraged itself and 2) you are also not excessively leveraged. I would draw the line at 1.5x for both.

[tede02]

An overlooked source of leverage for most individuals is a 401k loan.  The amount you can borrow is usually limited but you pay yourself back the interest.  Haven't done it myself, but I keep it in the back of my mind for the rare opportunity when (or if) I find an extremely high probably investment.

 

huh????

 

The purpose of leverage is to increase your balance sheet so you can make more income. But borrowing from your 401k is moving it from one place in your balance sheet to another?  And of course there is the double taxation issue.

 

 

 

The only advantage to borrowing from 401k is to invest in things you cannot invest in your 401k. But there is just such a high cost.

 

This is not accurate.  When you borrow from a 401k, you are not withdrawing money from your account.  The 401k plan is issuing you a loan and in-effect, your 401k holdings are the collateral. 

 

Also of note, some plans do not allow for loans.  It's up to the business owner when they establish the plan.

 

I need to make a correction here.  After reading more on this topic, a 401k loan does not provide financial leverage as I previously implied.  Randomep was correct in that it is in fact moving assets from one spot on the balance sheet to another.  However, a loan from a 401k plan does allow you tax free access to up to $50k of your 401k account balance.  The "interest" you pay on the loan is paid back to your own account.  Some have noted that you're repaying your loan with after-tax dollars.  This is true, but the loan is received free of taxes to begin with so its a wash.  The "interest" you pay yourself would be paid back with after-tax dollars however.  My apologies for the mistatement.  A 401k loan can be a cheap way to get cash, but it does not provide financial leverage as such. 

[jmp8822]

An overlooked source of leverage for most individuals is a 401k loan.  The amount you can borrow is usually limited but you pay yourself back the interest.  Haven't done it myself, but I keep it in the back of my mind for the rare opportunity when (or if) I find an extremely high probably investment.

 

huh????

 

The purpose of leverage is to increase your balance sheet so you can make more income. But borrowing from your 401k is moving it from one place in your balance sheet to another?  And of course there is the double taxation issue.

 

 

 

The only advantage to borrowing from 401k is to invest in things you cannot invest in your 401k. But there is just such a high cost.

 

This is not accurate.  When you borrow from a 401k, you are not withdrawing money from your account.  The 401k plan is issuing you a loan and in-effect, your 401k holdings are the collateral. 

 

Also of note, some plans do not allow for loans.  It's up to the business owner when they establish the plan.

 

I need to make a correction here.  After reading more on this topic, a 401k loan does not provide financial leverage as I previously implied.  Randomep was correct in that it is in fact moving assets from one spot on the balance sheet to another.  However, a loan from a 401k plan does allow you tax free access to up to $50k of your 401k account balance.  The "interest" you pay on the loan is paid back to your own account.  Some have noted that you're repaying your loan with after-tax dollars.  This is true, but the loan is received free of taxes to begin with so its a wash.  The "interest" you pay yourself would be paid back with after-tax dollars however.  My apologies for the mistatement.  A 401k loan can be a cheap way to get cash, but it does not provide financial leverage as such.

 

You pay back the loan with after-tax dollars. You also pay back the interest with after -tax dollars. The interest is 'new money' to the account. You do not get to deduct this interest amount like you would a traditional 401k contribution, when you save money from your paycheck.

 

The expensive part is at retirement, when you take out this 'new money' interest that you paid with after-tax dollars. You have to pay income tax again. There are many disadvantages and tax risks to 401k loans for credit-worthy consumers.