Two weeks ago, we discussed the possibility of building a portfolio worth roughly 25K without a single penny in hand. This is called leveraging. Borrowing to invest on the stock market was very popular from 2003 to 2008. Since the market crash, most individual investors have stopped using leveraging as a strategy, incurring important losses. While small investors got burnt and gave up, bigger investors (such as hedge funds) are still in the hunt with leveraging. After seeing what is happening on the market right now, I think that borrowing a few thousand could do a lot of good for my portfolio. At the moment, I am considering borrowing money to invest in the stock market but I won’t start until January if I even do it. In the meantime, I’m getting ready to make a move. I’ve leveraged several times over the past 8 years and want to share my way of doing it with you. So here we go!
Borrowing to invest, start by… borrowing!
In my opinion, the financing structure is the most important part of a leveraged portfolio. No matter how great your stock picks are, if your debt structure is not flexible enough, you may end-up with some real problems.
In an ideal world, you are able to borrow a significant amount at a low interest rate requiring interest only payments. This can be done if you qualify for a home equity line of credit (HELOC). I already have mine setup from a while ago since as I have used it before for the same purpose. If you can’t go with a HELOC, your other option is to refinance your house with a separate account (important, especially for Canadians in order to be able to deduct interest paid on the loan). I’d suggest extending the amortization to the maximum in order to give you as much flexibility as possible.
The other option if you won’t want to touch your house would be to open a margin account with your broker. However, the margin account has 2 disadvantages:
1) It requires you to first deposit an amount of money (you are given a line of credit according to the assets in your account)
2) You will be required to maintain a certain level of value in your portfolio (called a default clause where you would be required to inject liquidity into the account if your stock values fall)
This is why I think that using your house as collateral is the best way to borrow money at low rates and have all the flexibility in the world in terms of repayment strategy.
Carefully select your stocks…duh!
Yeah… right… you are going to tell me that it’s a no brainer, huh? But let’s go deeper in the “stock picking process”. If you want your dividend stocks to pay for your loan interest (so your leverage loan is almost “free”), you need to make sure that you have built a solid portfolio. More than that, in order to be successful, you need to look at both dividend growth and capital gain potential. Since your dividends will be used to pay off your loan, you will be left to count on capital appreciation to make money from your loan.
This is why stocks like KO and JNJ should not make the cut in your dividend selection. Because both companies are as stable as a rock and this is not what you are looking for when leveraging. If your borrowing rate is between 3 and 4%, you need stocks that will not only pay a similar yield in dividends but that will also generate some growth at the same time.
Seems like mission impossible? Not right now, and this is why I’m talking about leveraging at the end of 2011! When you look at both stock markets (US and Canadian), you can find several high paying dividend stocks that should also produce some capital appreciation. Some of them will be generated in a traditional manner (through posting higher profits and revenue growth) while others will generate capital gains because you buy them cheap when they are undervalued (INTC was a good example of this in 2011).
I’m usually more aggressive in my picks when leveraging. While it may seem counterintuitive to select more aggressive stocks when you are adding more risk with a loan already, yet the point of leveraging is to make aggressive returns to be able to pay off the loan and make a profit at the same time! This is why I tolerate slightly higher dividend payout ratio, for example, in exchange of more potential growth.
Be Ready To Pull The Trigger
When you build your leveraged portfolio, you may want to be more active than when managing your “regular” dividend account. The main reason is that you can easily trigger a sale out of a stock if you have made a great return already. Since you are seeking growth, if you can make 20% off a stock on a quick trade, you might want to sell it and cash in the profit to reduce your leverage. This is another advantage of having a line of credit attached to your account: you can reimburse and borrow the money at will. So whenever I made a profitable trade, I used to cash out the money and pay back my line of credit and wait for another buying opportunity before pulling the trigger again.
Set an Exit Strategy
It is very important to have an exit strategy when you are leveraging. If not, you could get greedy and always invest more. In one way or another, you must plan a way to pay off your loan. Ideally, you should first have a plan with your investments and another one with your budget.
Unfortunately, this strategy is not risk-free. If your investments tank because you didn’t pick the right stocks, you will still have to reimburse your debt. This is why it is also important to not borrow too much if this is your first try with leveraging. You don’t want to owe 100K and have investments worth 75K! In other words, if you borrow money to invest, you should be ready to lose this money and pay off the debts without getting into some serious financial problems.
Are you planning to use leverage in 2012?
At the time of writing this article, I am fairly convinced that starting a leverage operation in early 2012 will be a good deal. In fact, my decision will not be influenced by economic or stock market data (I think that both are highly favorable to a leverage strategy) but more oriented according to my own personal situation. I will have to evaluate my budget and determine if this is the right time to pull the trigger or not. Are you following the same train of thought or are you too afraid of the market to leverage right now?