Mechanical Margin, A Reprise
by MF DowMan

Some time ago, I wrote a Fribble explaining how the use of a little leverage can spice up the returns on those boring blue chips we recommend so often with the Beating the Dow strategy. Now that the Investing for Growth primer has hit the FoolMart sales rack, a number of people have asked me to do a similar piece for the IFG approach.

There are a few technical problems with such an analysis, so accept this in the spirit it is intended; it's a rough guideline for you to see what effect a conservative bit of margin buying can have on your portfolio when using a purely mechanical investment technique.

Here are the limitations I see for the model analysis; the sharp-eyed among you will undoubtedly find others: 1) The margin rate doesn't remain constant over time, of course. Right now, the broker's call rate is 7.5%, so I've used that figure in the analysis. When the cost of borrowing money rises, however, the benefits from margin decrease. When interest rates drop, the cost of margin is lessened. 2) The Investing for Growth portfolio doesn't hold each position for one full year and then re-load, so the idea of even margin costs is also only an approximation. 3) And finally, of course, I'm not accounting for taxes. No model can do justice to the range of factors and individual situations each taxpayer represents. Taxes are a consideration in any investment, naturally, but it's not feasible to build them into such a model. If you want my thoughts on taxes and IFG, I've written a separate Fribble outlining those thoughts.

With those disclaimers behind us, let's play with some numbers!

I said in my Beating the Dow Fribble about margin that I believe a conservative limit on margin purchases should be around 20% (not the 50% allowable by law). That means you're buying 25% more of each stock than you have cash for, and paying 7.5% annual interest to your broker for the right to borrow it. As of today, the regular IFG model portfolio stands at a value of $2,611,143. If we end the year at that level, the 16 years would represent an average annual compound rate of 28.0%. We'll use the same IFG historical annual returns and add 20% margin every year; here's what it does to the numbers:

In the first year, we would have borrowed $12,500 to add to the original $50,000, giving us $62,500 to invest. The IFG return in 1980 was a whopping 84.92%, leaving us $115,575. We would have paid back the $12,500 we borrowed plus 7.5% interest (a total of $13,438). That would have left us with $102,138 after Year One.

The next year was the biggest loser for IFG, so let's see how margin works in a losing year and then we'll fast-forward to the conclusion. Year Two would have begun with $102,138. We would have borrowed $25,534 and invested a total of $127,672. In 1981, IFG lost 14.52%, which would have dragged the total down to $109,134. After paying back the borrowed money and interest ($27,449), we would have had a total of $81,684.

You've now seen the "agony and defeat" of margin investing. It magnifies both your gains and your losses. With an approach, however, that wins much more often than it loses (like both Beating the Dow and Investing for Growth have), the long-term outlook looks inviting for using a conservative level of margin.

Let's jump to the end of the sixteen years. At the close of 1995, assuming the year were to end with today's value, the 20% margined IFG portfolio would have grown to $4,394,648 (compared to the regular IFG portfolio worth $2,611,143). That represents a compound annual return of 32.3% versus 28.0% for the traditional Investing for Growth method.

Even a very conservative level of margin can boost the overall return enough to make it worth considering. For instance, if you had purchased only 10% more than your cash on hand would allow instead of the 25% in the first example (representing just over 9% margin instead of 20%), the IFG portfolio would have grown to $3,237,279 during the sixteen years. That represents a 29.8% compound annual return.

Margin investing can raise your overall portfolio returns over time if you are able consistently to achieve a return greater than the interest rate you must pay to borrow the money. Keep in mind that margin's power is equally effective in bear markets, though. Margin exaggerates both good and bad results. In the long run, however, an approach like Investing for Growth seems like a classic candidate for a little leverage.