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Monday, February 16, 2009

Investing and the Use of Leverage

Investing and the Use of Leverage

Many investors see the current bear market and economic slowdown as a reason to sell stocks. We believe the opposite action should be taken and that investors may think about using leverage to increase their potential net worth. Here’s why:

The current situation for real estate, bonds and equities

In Canada, the real estate market has been buoyant these past several years and has begun to slow as prices have levelled off. People who wanted to purchase a home have done so and they are probably content to stay in that residence for the next 10-15 years. Therefore, the real estate market is not as appealing an investment as it once was. We think that future returns should continue to be decent but are unlikely to mirror those of the past decade.

We believe that the bond market, perceived to be a safe haven from a collapsing U.S. economy, is now overbought. That’s because real returns (after tax and inflation) are now negative.

Currently, the 10-year Government of Canada bond yield is 3.4%. After 50% tax (interest income) and inflation (2.25%), the real return is –0.55%. This means that investor spending power against tax and inflation is falling, not growing.

As a result, we believe there’s more risk inherent in the bond market and that risk could increase if the U.S. Federal Reserve Board quickly raises rates once the financial sector stabilizes – an increase in interest rates causes bond prices to fall.

Equities, meanwhile, have been in a bear market (down 20% or more from the market peak last October) as the economy has entered a contraction phase of slower or even negative growth. But this economic phase should not last forever. We think there’s a tremendous opportunity for growth in the equity market.

The opportunity in equities

While stock market corrections are unsettling, investors must understand that four things remain static, even in a bear market:

1) Stock prices will fall in a bear market but the capital is not lost unless it is sold. It’s more important for investors to remember that they are making an investment in a business with an expectation of a payback on that capital over time, usually through a combination of dividend payments and price appreciation.

2) If the financial health of the company is solid, dividends should continue to be paid, giving investors income to buy more shares at cheaper prices, waiting for the day when the stock market recovers.

3) As dividends rise, stock prices ultimately follow.

Consider a stock that trades at $20, pays a $1 dividend and yields 5% ($1 divided by $20). If the dividend subsequently rises $0.20 a year for five years to $2:

At $20, the yield will be 10%. Given such a high yield, investors would be attracted to buy that asset. For the stock to return to its previous 5% yield, the share price would have to rise to $40, eventually earning a positive capital return for the investor in addition to their growing income stream.

4) A “slingshot effect” usually occurs and the market rebounds before investors recognize it. Just before the U.S. invaded Iraq, the stock market reached its last low on March 11, 2003. Nobody wanted to own equities then because the fear of war tends to wreak havoc on economies, causing markets to tumble.

It wasn’t until 2005 that many investors felt comfortable enough to buy equities again. Unfortunately, this was a huge missed opportunity. The “slingshot effect” in this case was a 45% stock market decline from 2000 to 2002 followed by a 50% rally from 2003 to 2005.

Those investors who stayed in equities and used the market decline as an opportunity to buy more stocks, earned better-than-average returns when the market recovered.

We believe that opportunity has re-surfaced in the stock market.

1) Some dividend yields are as high now as they have been in 35 years.

2) If there is another 20% drop in the market, price-earnings ratios would be at their lowest since 1975, a period that signalled the beginning of the greatest bull market of the 1980s and 1990s.

3) Globalization has given corporations a chance to sell into greater and more diverse markets, especially in emerging markets where per capita incomes have risen much faster than in the more mature G7 countries.

There are generally three stages in a bear market:

• The first - when just a few prudent investors recognize that, despite the prevailing bullishness, things won’t always be rosy,

• The second - when most investors recognize things are deteriorating, and

• The third - when everyone is convinced things can only get worse.

Certainly we’re well into the second of these three stages. There’s been lots of bad news and many write-offs. More and more people recognize the dangers inherent in things like innovation, leverage, derivatives, counterparty risk and mark-to-market accounting. And increasingly the problems seem unsolvable.

One of these days, though, we’ll reach the third stage, and the herd will give up on a market turnaround. And unless the financial world really does end, we’re likely to encounter the investment opportunities of a lifetime.

What is leverage?

Leverage is the action of taking the value of an asset or the steady income stream of a salary and borrowing against it. For example, individuals can take out an investment loan based on a percentage of the equity in their house - the difference between the appraised value of the house and any mortgage outstanding.

Another way is to borrow against your annual income. If you have consistent earnings, the bank will lend you a percentage of your annual income based on your ability to pay, net of all other expenses.

The purpose of leverage is to have more capital available to earn a greater return over time than if you just had a small amount of cash savings to invest.

It’s even more attractive because the government allows you to deduct a portion of the interest paid on your income tax return.

For example, if you own a house worth $600,000 and the mortgage has just been paid off, the bank may lend you up to 80% of the appraised value of the house in the form of an investment loan, or $480,000.

With the loan, you now have over $1 million of total assets that can grow and compound over time.

Given that interest rates continue to trend lower, the low cost of capital is making it attractive to use leverage through an investment loan.

For Canadian investors, the Bank of Canada is expected to keep pace with the Fed and reduce interest rates. This should lower the prime rate offered by the banks.

For example, if you take out a loan at 6%, the after-tax cost of capital would be roughly 3%. If that capital is invested in a stock that yields greater than 3% after-tax, the interest can be covered by the dividend income and the residual amount can grow through time and compounding to an amount greater than the loan.

What rules should be followed when using leverage?

While leverage helps capital grow over time, there is a downside. That occurs if the investment falls during the period of the loan. If the investment went to zero, there would be no capital growth but the debt would still have to be serviced.

That’s why it’s important to use some disciplined rules if you decide to use leverage:

1) Buy only dividend-paying stocks.

These companies should be more mature (large-cap, blue chip names) and have a proven track record of annually raising dividends.

Another benefit of dividend-paying stocks is that the yield should help set a floor as to how low the stock price may go, relative to current bond yields.

Non-dividend-paying stocks have no guarantees of growth. Unlike dividend payers, their share prices will be determined by their earnings. If the earnings disappear, the share prices will plummet.

2) The holding period should be 10-15 years.

Using leverage isn’t a get-rich-quick scheme. When buying stocks (with or without leverage), it’s important to let the companies grow through economic cycles.

This becomes clear if you leveraged at the worst possible time in the market, such as when the technology bubble burst in 2000. For anyone leveraging their portfolios in 2000-2001, a significant amount of time was needed for the investments to increase in value.

3) Borrow only what you can afford to pay monthly.

Do not extend yourself by borrowing too much. Decide first how much you can afford monthly to pay on the loan. The bank can then determine how much they will lend you.

4) If you currently have a mortgage, don’t leverage further.

Your mortgage is the highest after-tax cost you will face in your lifetime. It is more important to pay off this debt as soon as possible. Once the mortgage is paid, you can then decide if you wish to leverage the equity in the house in the form of an investment loan. A simple method is to borrow an amount that makes the monthly payments similar to your previous mortgage payments.

5) Retirees should not leverage.

During retirement, it is essential to be debt-free. Using leverage would be a dangerous strategy because there is no guaranteed income stream like a salary and bad investments could wipe out your retirement nest egg or worse, force you back to work.

6) The new Tax Free Savings Accounts – TFSAs may be an attractive use of leverage.

These accounts were introduced in the recent federal budget and should begin in 2009. The guidelines are that individuals may put $5,000 annually into this tax shelter. Because there is no tax liability and funds may be withdrawn without penalty, the after-tax cost of using leverage would be minimized.

For investors who can afford to leverage, who have the time-horizon to use it and who understand the inherent risks behind the strategy, we believe this may be an ideal time to do so.

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