<FOOLISH FOUR PORTFOLIO>
Superhuman Feats
Making the most of limited resources
by Ethan Haskel ([email protected])
BALTIMORE, MD (July 14, 1999) -- I don't usually go around bragging about this, but I'm strong enough to lift the family car up off the ground. No, this car's not one of those puny Geo Metros, but a good old hefty minivan, weighing in at over 2.5 tons. In fact, I've hoisted such autos many a time, and I can train you to do the same.
Sorry to say, this tale is not one of steroid-enhanced deltoids or abs. Rather, it's about using simple tools to achieve what appear to be superhuman feats. With just a few basic instruments, we cannot only bend steel with our bare hands, but also achieve a guaranteed annual investment return of 200%. That guaranteed 200% is not a misprint -- you'll hear more about that later.
The tool that can accomplish these wondrous acts is the simple lever. The lever allows us to most efficiently harness limited resources to achieve ambitious goals -- whether they be physical or financial. All that's required to lift that minivan is a car jack, the quintessential lever. By placing the fulcrum of the lever very close to a heavy object, we can move a maximum weight with a minimum effort. Anyone who has pulled a nail out of a two-by-four with the back end of a hammer has employed the same principle.
We can also use this magnificent lever to achieve seemingly superhuman investment feats. By leveraging our limited capital, our money can work a lot harder for us. Here are a few (necessarily oversimplified) examples of leverage in action.
Possibly without knowing it, many of us use leverage when we buy a house. Making a down payment of 10% on a $100,000 house costs us $10,000 up front. If the dwelling should appreciate 5% over the next year, you've gained $5,000, but your actual return that year would be not 5%, but rather 50% (a $5,000 profit on an intital investment of $10,000). The lever strikes again! The "fulcrum" that makes the lever work in this case is your mortgage loan.
Another way of using leverage to jump-start your investment returns is the use of margin. When we invest with margin we borrow from our broker in order to buy more shares of a stock than we might otherwise. The fulcrum for this lever is the margin loan. For instance, let's say we wanted to buy 200 shares of General Gigantic (Motto: "GG --We bring good things to height"). With GG priced at $50 a share, our initial investment would come to $10,000. Should the stock go up 20% this year, we've made a nice profit of a $2,000. Not bad.
Using a modest amount of margin, with the same initial $10,000 investment, we can buy a total of, say, 240 shares -- 200 with our initial investment dollars and 40 shares with $2,000 borrowed from the broker. Since we now own 240 shares at the beginning of the year, a 20% gain ($10 per share) in the price of General Gigantic nets us a profit of $2,400 at year's end. A gain of $2,400 on an initial investment of $10,000 means we've juiced our gains to 24% for the year (minus interest charges paid to the broker for the margin loan).
Using this strategy over the long run, especially for relatively sturdy Foolish Four or Beating the S&P (BSP) stocks, can have large effects on the final value of a long-term retirement portfolio.
But margin investing has a dark side. Occasionally, stocks have a nasty habit of losing value. Should General Gigantic have growing pains, so to speak, its stock might get clobbered 20%, or even more. A $10 drop in the price of GG would have resulted in a loss of $2,400. That's a 24% loss on your initial investment, plus the cost of margin interest. Remember, the margin loan doesn't shrink just because stocks purchased with it go down.
If the losses get too high they can potentially trigger the much feared margin call. In such a call, our broker asks us to place more money into our account -- or else sell some of the margined shares. That's why Fools shy away from excessive use of this potentially powerful tool.
Okay, what about those guaranteed 200% annual gains I promised? They are absolutely achievable, through the use of my favorite leverage tool of all -- time. Using time as the fulcrum in our lever accomplishes financial feats unmatched by any Herculean market guru.
Here's how the time-lever works. Let's invest $10,000 in Foolish Four or BSP stocks now, and assume a fairly conservative 15% annual rate of return -- a return significantly lower than the long-term 20% average returns for the Foolish Four. After 25 years of 15% returns, our original $10,000 investment has grown into a tidy $330,000 nest egg. Congratulations for sticking with the program!
Let's take that $330,000 nest egg and invest it in United States 30-year treasury bonds, backed by the faith of good old Uncle Sam. If held for the full term, these bonds are as safe an investment as you'll find anywhere. Since these treasury bonds are now paying about 6% interest per year, we'll have achieved a return of about $20,000 the first year.
So there you have it. By using our magical clock-lever, we've managed to create an annual $20,000 risk-free profit on a single $10,000 investment -- a guaranteed 200% return each and every year. Should we decide instead to roll over our nest egg into stocks rather than bonds, a 15% return on our $330,000 pot would create an additional $50,000 or so the next year. That's an annual return of -- you guessed it -- 500% on our original $10,000.
The ancient Greek mathematician-inventor Archimedes (c. 287 BC-212 BC) recognized the true value of many simple tools, including the lever. He wrote, "Give me but one firm spot on which to stand, and I will move the earth."
Let's see now, 10,000 drachmas invested at 15% for 2200 years will earn... hmmm!
[Editor's Note: Following are the returns of a "paper" Beating the S&P portfolio that Ethan has been reporting on in the Foolish Workshop for many months. The stocks were selected December 31, 1998, and "purchased" in equal dollar amounts to be "held" for one year. To see a list of stocks for portfolios starting now, see Today's Stock Lists.]
Beating the S&P year-to-date returns (as of 07-13-99):
Schlumberger <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SLB)") else Response.Write("(NYSE: SLB)") end if %> +38.1%
Kimberly-Clark <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KMB)") else Response.Write("(NYSE: KMB)") end if %> +2.0%
Campbell Soup <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CPB)") else Response.Write("(NYSE: CPB)") end if %> -20.6%
Ford Motor Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: F)") else Response.Write("(NYSE: F)") end if %> -7.3%
Bank of America <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BAC)") else Response.Write("(NYSE: BAC)") end if %> +24.3%
Beating the S&P +7.3%
Standard & Poor's 500 Index +14.0%
Compound Annual Growth Rate from 1-2-87:
Beating the S&P +20.6%
S&P 500 +18.4%
$10,000 invested on 1-2-87 now equals:
Beating the S&P $102,400
S&P 500 $81,200
Today's Stock Lists | 1999 Dow Returns
07/14/99
Close
Stock Change Last -------------------- CAT - 1/16 59.81 JPM + 1/8 138.38 MMM -1 7/16 88.00 IP +1 1/16 54.06 |
Day Month Year History
FOOL-4 +0.06% 1.47% 27.62% 29.51%
DJIA -0.24% 1.62% 22.21% 21.72%
S&P 500 +0.33% 1.85% 14.32% 14.60%
NASDAQ +1.43% 4.92% 28.51% 30.27%
Rec'd # Security In At Now Change
12/24/98 24 Caterpillar 43.08 59.81 38.84%
12/24/98 9 JP Morgan 105.51 138.38 31.15%
12/24/98 22 Int'l Paper 43.55 54.06 24.14%
12/24/98 14 3M 73.57 88.00 19.61%
Rec'd # Security In At Value Change
12/24/98 24 Caterpillar 1034.00 1435.50 $401.50
12/24/98 9 JP Morgan 949.62 1245.38 $295.76
12/24/98 22 Int'l Paper 958.12 1189.38 $231.26
12/24/98 14 3M 1030.00 1232.00 $202.00
Dividends Received $49.99
Cash $28.26
TOTAL $5180.50
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