The Daily Workshop Report
by Robert Sheard (TMF Sheard)

LEXINGTON, KY. (Apr. 8, 1997)

Since writing about the use of margin leverage in a number of recent columns, several readers have asked me to go into more detail about how margin leverage works. So let's look at a couple of scenarios.

Johnny Aggressive has $50,000 in his brokerage account, waiting to be put to work. The current margin regulations restrict the amount one can borrow to 50% of the total invested, so Johnny can borrow up to another $50,000 under these rules. (Of the $100,000 he'd invest, 50% has to be his own money.)

My belief is that 50% on margin is too risky unless you're sitting on a lot of cash elsewhere you can use to meet a margin call should your stocks slump considerably. For those of us who are fully invested, however, a more conservative level of margin is more appropriate, say 20% to 25% on margin. (With 25% margin, you're borrowing a buck for every three of your own.)

Right now, margin interest rates your broker will charge you run roughly from 7% to 9% a year. Let's put Johnny's portfolio through its paces. Assume he uses 25% margin and his broker is charging a middle-of-the-road 8% rate.

The first year, he'd invest $66,667 ($50,000 of his own and a borrowed $16,667). If he achieves a 20% return, his profit for the year is $13,333, giving him a total of $80,000 before paying back the loan with interest. Pay back the $16,667 and the 8% interest and the total is $62,000. Using the margin, then, turned a 20% return into a 24% gain. Compound 4% a year for 20 years or so and you're suddenly talking about real money.

Without any margin, a 20% annual return would turn the original $50,000 into $1.9 million. Add in the 25% margin (at 8% interest), though, and the total jumps to $3.7 million over the same 20 years in the exact same investments. (These numbers exclude taxes, of course, but taxes don't change the principles, just the raw numbers involved.)

Of course, leverage also increases your risk in a down market. If it can boost a 20% return on the upside to 24%, it has the same exaggerating affect to the downside. In a year like 1990, for instance, when even the Dow Approach got whacked for more than a 15% loss, a margined portfolio might have been looking at losses greater than 20%.

Overall, though, for a stable approach with a great long-term record, margin isn't a bad proposition if, like most things, it's used reasonably. One good tactic Knowles & Petty point out in their book, The Dividend Investor, is to use margin in years after the Dow has lost ground. Ninety percent of the time, this has been a money-making proposition. With the Dow Approach's consistent returns, though, I think it can be used regularly, within reason, of course. Is there a theme here or what? Fool on!

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