The Daily Dow
Wednesday, August 27, 1997
by Robert Sheard
LEXINGTON, KY. (Aug. 27, 1997) -- With the change in the required holding period to qualify for long-term capital gains treatment, a number of readers have inquired about how I would use margin investing on the longer cycle as a regular savings vehicle for my monthly additions to the market. It gets a little more complicated with the longer cycle, but of course, the principle is the same.
First the assumptions. All stocks are held for 18 months (and a day) to qualify for the 20% capital gains tax rate. The pre-tax annualized return is 18%, the historical rate of return on the high-yield ten since 1971. (Over an 18-month period, that equates to a return of 28.18%.)
Each 18-month cycle, the investor borrows an additional 25% of the portfolio's starting value. That equates to starting out with 80% owner's capital and 20% on margin.
The opening value of the portfolio is $20,000 and the investor saves $5,000 over the course of 18 months. (Each subsequent 18-month period, his savings amount increases by 3% to account for increases in his income and savings rates.)
Margin interest is charged at an annual rate of 7%. Over 18 months, this equates to a rate of 10.68%. In this calculation, I'm actually overstating the interest charges because I'm assuming the investor pays the interest on the original amount borrowed in each period for the whole 18 months. In reality, each monthly savings deposit would reduce the margin balance, and thus the interest charged over the 18 months.
And finally, it's assumed that every stock turns over every update, so taxes are paid each 18 months on the entire gain for the previous cycle, again a possible over-statement of costs as many stocks stay in the group for more than one cycle.
I'm willing to overlook trading costs because of the low-cost brokers available and the overstatement of charges I've allowed in other parts of the hypothetical model.
Let's go through the process:
At the start of year one, our investor has $20,000 and borrows another 25% ($5,000), investing a total of $25,000 in the High-Yield Dow stocks. After 18 months, the profit is $7,045. The tax owed (20% of that profit) equals $1,409, and the margin interest owed on the original $5,000 loan equals $534. After he pays back the loan with interest and pays the taxes, he's left with $25,102. Now during the 18 months, he's also put away a total of $5,000 in monthly savings deposits, so his actual cash balance at the end of the first 18 months is $30,102.
Now he starts the process all over again. Beginning with $30,102, he borrows 25% (or $7,526) and invests the total ($37,628). The return after 18 months (at an annual rate of 18%) is $10,603. After he pays back the loan plus $804 in interest, pays $2,121 in taxes, and adds his total savings for the 18 months ($5,150), his new grand total is $42,931.
If he were to keep following the same cycle over 30 years -- starting with $20,000, using 25% margin, earning annual gains of 18%, and saving monthly at a modestly growing pace -- his portfolio would swell to an amazing $3.9 million.
I personally like this approach for any investor who adds to his account regularly. First of all, the level of margin is relatively conservative and unlikely to trigger a margin call in a market downswing because you're staking the portfolio with 80% of your own money.
Second, you only have to keep up with a single portfolio every 18 months, rather than trying to buy and sell stocks every month or quarter as you add new money. This also saves on trading costs, even though they're relatively low to begin with.
Third, your monthly savings deposits are already at work for you before you even put them in your brokerage account. Each monthly payment simply pays down your margin balance, the interest on which is also a tax deduction.
And fourth, with a consistent strategy like the Dow Approach, you will typically achieve returns that are higher than the interest rate you must pay for the borrowed money on margin, thereby juicing the already impressive Dow Approach returns even further.
For a regular saver who wants to be aggressively conservative and wants to keep life as simple as possible, a regular amount of margin leverage may be the answer. Fool on!
(c) Copyright 1997, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool. ________________________________
Stock Change Last -------------------- T + 1/8 40.13 GM - 13/16 64.19 CHV +1 3/4 80.00 MMM - 3/16 91.56
Day Month Year
FOOL-4 +0.29% 3.76% 9.89%
DJIA +0.07% -5.29% 20.77%
S&P 500 +0.07% -4.26% 23.35%
NASDAQ +0.27% 0.11% 23.59%
Rec'd # Security In At Now Change
1/2/97 153 Chevron 65.00 80.00 23.08%
1/2/97 179 Gen. Motor 55.75 64.19 15.13%
1/2/97 120 3M 83.00 91.56 10.32%
1/2/97 479 AT&T 41.75 40.13 -3.89%
Rec'd # Security In At Value Change
1/2/97 153 Chevron 9945.00 12240.00 $2295.00
1/2/97 179 Gen. Motor 9979.25 11489.56 $1510.31
1/2/97 120 3M 9960.00 10987.50 $1027.50
1/2/97 479 AT&T 19998.25 19219.88 -$778.38
CASH $1009.44
TOTAL $54946.38