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Safe(-ish) Margin Leverage - Tell Me I'm Wrong...


Voodooking
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So I used to run a non-leveraged, zero margin portfolio, for all the traditional reasons that are cited by respected value investors and generally wise people.

 

I then read 'Snowball', the Buffett biography, and the Buffett Partnership Letters, where I discovered that Charlie Munger grew his wealth by using lots of leverage (as I know how smart Charlie is, this was probably non-recourse debt, but still leverage). I also discovered that Warren Buffett used margin in his BPL accounts, but only up to a 'self-imposed limit' of 25% maximum of the portfolio value.

 

This made me think. If one is confident of superior returns, and has access to non-recourse lending, then leverage only "gets you where you are going faster", whether that's a profit or a loss situation.

 

I am well aware of the pitfalls of margin calls and the risk of having to liquidate position(s) at the worst possible time. However I began to wonder whether there was a "safer" way of using leverage...?

 

I run a series of small portfolios and have been experimenting with using margin leverage on some of them. For example, say the portfolio value is $10,000 ...I would request a margin of $10,000 on the account, yet employ Buffett's rule of limiting margin leverage use to only 25% of portfolio value ($2,500).

 

At the moment, I feel that this allows me to take advantage of a small amount of leverage, while protecting my downside by knowing that because I have several thousand dollars of 'free' margin available to provide a cushion / margin of safety if the market does drop or correct. This would obviously subsequently vastly reduce my available margin, but shouldn't force me to sell positions.

 

I'm looking to 'Stress Test' this idea and invite comments from other board members and look for them to suggest weak points in this strategy that I may not have considered.

 

Look forward to hearing from you.

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Yes, I am almost always utilizing it. It really does come down to knowing when to bet big or otherwise simply constructing the portfolio to be lower risk. A diversified portfolio of preferred stock or investment grade bonds levered 3:1 likely won't kill anyone. Especially if actively and competently managed. Same thing for a low beta portfolio with holdings that have little correlation. I also like using leverage to put on merger arb plays. Essentially if each position is viewed as an independent opportunity to make money, It's a little different than just being a pig and wanting 2x the returns of such and such security.

 

Additionally, I have certain equity positions that I am comfortable with my understanding of in terms of volatility and risk. For instance, there are certain positions I will margin 100% as I am confident in their stability. IE GM in the low 30's I determined to be: cheap at 4-5x earnings, supported via a 5% dividend yield, have a margin of safety with 35% of mc in cash, and stable future cash flows given my views on the auto market. I viewed the "volatility risk" as downside being mid to high 20's. So a draw down from 32 to 25 wouldn't exactly kill me. This is just an example. I evaluate this kind of stuff on a case by case basis. I don't view it as risky as I'm comfortable with what I own and confident in my assessments. If I'm wrong I'm cool with that. The chances of the things I'm invested in "never coming back" are very remote. My leverage typically hovers around 1.3.

 

As a side note, if I remember correctly, in 2009, the year Tepper did 100%+, he was levered like 3-4:1. Sometimes you just go with your gut.

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The problem I have with leverage is that you can’t buy if the market crashes. You’ll just be trying to hang on. I went into the crashes in 2000 and 2008 with no leverage, but I leveraged up after the drop. I want always to have staying power and the capacity to borrow and invest at the bottom.

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The problem I have with leverage is that you can’t buy if the market crashes. You’ll just be trying to hang on. I went into the crashes in 2000 and 2008 with no leverage, but I leveraged up after the drop. I want always to have staying power and the capacity to borrow and invest at the bottom.

 

This is how I envision the best use of leverage. I use call options to achieve upside leverage in a typical market cycle. It's more expensive, for good reason, but won't kill your cash position/flexibility in a downturn.

 

Margin seems mostly suitable for a market that has dropped 30-50% where you can be loading up at the bottom and slowly pay it off with dividend growth and capital gains over time.

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The problem I have with leverage is that you can’t buy if the market crashes. You’ll just be trying to hang on. I went into the crashes in 2000 and 2008 with no leverage, but I leveraged up after the drop. I want always to have staying power and the capacity to borrow and invest at the bottom.

 

I'd imagine it also then has something to do with one's ability to access leverage. One could very easily be modestly levered and still have liquidity in the event of a drawdown. If you are using leverage the single most important aspect is managing it. 

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Two questions that you may want to ask yourself:

Is it necessary?

Is it appropriate?

Many variables to look at including other personal sources/uses of cash flows.

Confidence in what you hold and the associated margin of safety also count.

Another variable to consider is to asses if what you hold is already levered.

 

 

Perhaps, in selected instances, starting with low or no leverage may give you courage in averaging down.

Margin interest is deductible but know the rules (specific to your tax jurisdiction).

Personal decision.

 

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The timing for net leverage > 100% is probably not optimal, but i can imagine using it after a bigger market drop. But i wouldn`t go with margin debt, i would just sell puts. That way you won`t have the full upside, but you are paid to wait instead of paying interest on your margin.

At the moment i do this and buy puts on overvalued/problem stocks to offset market exposure, so that the option premium in my whole portfolio is near zero and my net market exposure is only 30%. I think this is the cheapest and safest form to implement a long/short portfolio.

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To understand "base rate" of great people investing with leverage let's add a few more cases: Benjamin Graham used leverage. And he almost went broke. I believe it was money from Newman father or something like that which saved him. Keynes also used leverage and he also almost went broke... twice. First time saved by his father and second time by his friends. After that if I remember correctly he imposed a 10% limit on margin to total portfolio value.

 

By the way equity is a junior claim on a company cash flow and you are usually taking on operating and financial leverage when investing in equity. So, in financial terms a share is an option on the company cash flow. Levering up an option sounds like a little bit crazy idea for me. However it is just me, it does not mean that shrewd people cannot use leverage to their advantage.

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Anyone who's ever taken out a mortgage, a student loan, or even a credit card has utilized leverage. It all comes down to risk management.

 

Some other theoretical. I know plenty of people who own big real estate portfolios and as such have shitty liquidity positions. Is borrowing against the real estate to buy stock crazy? What about if you have 100k equity balance but are levered 3:1, owning 300k in a stock portfolio. But have 50% LTV on a 750k house, 50k in a checking account, and 100k invested in various small businesses? Do we apply what we consider leveraged to just the stock portfolio or one's entire net worth? In the case of net worth, said person is levered 2:1 on their house. Many might consider that, plus 3:1 on a stock portfolio, plus illiquid investments in local businesses to be very risky with only 50k cash on hand. I personally, would not consider that risky.

 

I think the biggest thing when discussing margin and/or leverage are understanding and being clear about the parameters in which it is being used.

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Some other theoretical. I know plenty of people who own big real estate portfolios and as such have shitty liquidity positions. Is borrowing against the real estate to buy stock crazy?

 

Well, I don't know. Probably it depends. If we are speaking about situations when houses became a financial asset (i.e. rreal estate market depends mainly on various forms of borrowing) it does not sound as a good idea. Obviously house prices may correlate with stock prices during credit cycle downturn. From the standpoint of risk management I would rather sell real estate right away to boost my investment capital. However it's just me, I'm paranoid about the downside.

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For me, the main thing with using leverage is structuring the duration of your financing with your type of asset.

 

If you have a long term asset like stocks or RE, you finance it with long-term financing as well. This means that the financing cannot be callable under no circumstance before the date that has been agreed upon. I consider margin on stocks as being risky, but mortgaging your house on a fixed long term (25y) to finance the purchase of stocks is not really risky.

 

You cannot afford to finance RE or stocks with funds that are callable in a short term even under certain unlikely circumstances. Most of the people investing in RE or stocks who went broke by leverage violated this rule. Plenty of people got broke not because of bad investments but because of a liquidity problem.

 

Buffett used plenty of leverage in his carreer, but always respected this rule. In the partnership days, it was the LP capital he used as leverage and margin leverage (=short term) on special situations which had a defined term.

In Berkshire he uses float which is not callable, or long term bonds in Midamerican or long term written puts (derivatives) which also are not callable before strike date.

 

 

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For me, the main thing with using leverage is structuring the duration of your financing with your type of asset.

 

This sums it up.

I wouldn't use leverage for a typical common stock investment. But for fixed income, or preferred shares, or a rental, or anything with stable, reasonably predictable income, I don't see why you wouldn't, provided you're comfortable with the additional risk it introduces.

 

Psychology plays a large role in this. Having been subject to margin calls in the past, I know how badly it can mess with your decision making process and confidence. Use of any kind of margin is dangerous for this very reason, but as long as it forces you to do more due diligence on the investment in question and implemented with a large enough margin of safety, I don't think it's a horrible thing.

 

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The key to using leverage is being creative in how you get it.

 

I think the lowest rung on the totem pole is margin leverage from a brokerage.  They will give it to you regardless, but they extract a high price in return.  They can take ANY of your assets if you have a margin call, no excuses.

 

Having suppliers finance you, or customers is another form of leverage.  Or extending payables beyond receivables in your business.

 

I personally prefer operating leverage.  Build a product once, sell it multiple times.

 

It's worth noting that very few to no one has become really wealthy from investing alone.  If you want to become wealthy create a business.  You'll note Buffett's business was managing money, same with Munger.  You need cash to be flowing in that you can re-invest.  If you start out with $10k and try to become a millionaire it is a tough slog.  Much easier to convince a bunch of friends you're some genius, get $1m from them, tear 1% off the top and take 10% of their gains and call it a day.  That's a business where the product happens to be investing.

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For me, the main thing with using leverage is structuring the duration of your financing with your type of asset.

 

If you have a long term asset like stocks or RE, you finance it with long-term financing as well. This means that the financing cannot be callable under no circumstance before the date that has been agreed upon. I consider margin on stocks as being risky, but mortgaging your house on a fixed long term (25y) to finance the purchase of stocks is not really risky.

 

You cannot afford to finance RE or stocks with funds that are callable in a short term even under certain unlikely circumstances. Most of the people investing in RE or stocks who went broke by leverage violated this rule. Plenty of people got broke not because of bad investments but because of a liquidity problem.

 

Buffett used plenty of leverage in his carreer, but always respected this rule. In the partnership days, it was the LP capital he used as leverage and margin leverage (=short term) on special situations which had a defined term.

In Berkshire he uses float which is not callable, or long term bonds in Midamerican or long term written puts (derivatives) which also are not callable before strike date.

 

I agree with Skanjete's point:

 

"You cannot afford to finance RE or stocks with funds that are callable in a short term even under certain unlikely circumstances."

 

I recall that in 2008/2009 some people had the terms of their HELOCs changed or they had unused credit lines were frozen or reduced.  You might think you will have access to liquidity from such a source and then it disappears right when you need it most.  During a financial crisis, unlikely circumstances become more common :)

 

During 2008/2009 didn't the list of marginable securities change?

Didn't the margin requirements at the brokers also change?

 

 

 

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My advice for listening to anyone’s opinion here is to only take advice from someone who is “pro-leverage” (however they define it), if they held that view/approach through a major recession.

 

If that is not satisfied, I believe you will get a lot of nice sounding opinions but with little real world practicality. I had sold a few (puts) during the last downtown and though the “leverage” was minimal I can assure you it made me quite uncomfortable.

 

I think personally leverage (of many types) can be quite wonderful. I do tend to agree with Nate though that short term, broker provided, callable leverage is probably the worst kind (although it is cheap).

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There are those who have rightly pointed out about duration matching. This is important.

There are others who have rightly pointed out callable/non-callable leverage should be determined by asset volatility. Also important.

Something similar could be said for the use of recourse/non-recourse debt.

 

Lastly, I think the correlation of the asset with the liability/leverage matters quite a bit. When do margin loans go bad? Typically when the market/name don't perform well. So what is appropriate use broker margin for? Shorting stocks, buying puts, buying long-duration bonds, etc. Items that would tend to do well in the environment that you'd expect to be called against. These would act as a natural hedge to the type of environment you'd expect margin calls to go bad in.

 

Something similar could be said about housing leverage. A mortgage is a short-position in interest rates. If you opt for the cheaper leverage in the form of a floating rate, when rates rise - the value of liability you're short rises AND the value of the asset held as collateral drops. A terrible situation for many in 2008 leaving many insolvent. A fixed rate mortgage may be more appropriate simply because it acts a natural counterweight to the asset volatility allowing for individuals to carry a significantly higher amount of debt more safely.

 

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Hey all:

 

I think that if you are going to use broker margin....obviously you want to pay the least amount in interest that you can.  Interactive Brokers & TradingDirect have some of the lowest rates...something like 2%.

 

Then I think that the next thing would be to only lever a portfolio 20% to 30%.  Don't go to the maximum...have some margin of safety.

 

Then have a portfolio of high yielding stocks.  Try to get them across wildly different industries.  Get some REITS, BDC's, MLP's and other individual high yielding companies.

 

Finally, use the 1st payouts you get towards lowering your debt.  That is, pay down debt heavily at first, then gradually lighten up.

 

I think this method would be reasonably safe.

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  • 2 weeks later...

There is nothing wrong with using margin responsibly. We're typically borrowers when prices are cratering and use it average down our cost base; when price returns to average cost we sell off enough to repay the margin. It really comes down to comfort, after-tax interest cost, and the attractiveness of the terms you are offered.

 

SD

 

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