Thursday, June 11, 1998

The Daily Workshop Report
by Robert Sheard (TMF Sheard)

LEXINGTON, KY. (June 11, 1998) -- A number of readers have pondered ways to spice up the already solid returns of many of our screens. Some of the methods posed have included sell-stops to limit losses, options to reduce the investment cost for controlling the same number of shares, and market timing.

For a variety of reasons, I have argued against all three methods. But that doesn't mean I'm against some form of leverage. I have long held that a very conservative level of margin leverage is a reasonable way for the experienced investor to boost returns with a mechanical approach like the Dow Approach or even some of the Workshop screens.

What is margin? Basically, it's a loan from your broker that allows you to buy more stock than you have money for in your account. The theory behind the use of margin is simple. If you can achieve portfolio returns higher than the margin interest rate you must pay your broker, you make an extra return by having used the margin leverage.

The dangers of margin, of course, lie in the facts that it's easy to overextend yourself if you get greedy (I'm uncomfortable with any margin higher than 20% of the total amount invested) and that margin cuts both ways. If your portfolio is leveraged and it goes down, your losses are exaggerated just as your gains would be in a good year.

Here's how the use of margin would have affected the Keystone 10 from 1986 through 1998. (I'm assuming a 7.5% margin interest rate.)

1986 -- Starting with $50,000 of the investor's own money in 1986, he would borrow an additional $12,500 from his broker. (Of the $62,600 he invested, 80% is his and 20% is the broker's, hence 20% on margin). The return was 23.8%, boosting that to $77,375. Pay back the $12,500 borrowed plus $906 in interest, and the final total for the year is $63,969.

1987 -- Borrow $15,992 in order to invest $79,961. The return was 11.3%, generating a sub-total of $88,997. Pay back the loan plus $1,159 in interest, leaving $71,845.

1988 -- Borrow $17,961 in order to invest $89,806. The return was 6.9%, generating a sub-total of $96,003. Pay back the loan plus $1,302 in interest, leaving $76,739.

1989 -- Borrow $19,185 in order to invest $95,924. The return was 52.6%, generating a sub-total of $146,380. Pay back the loan plus $1,391 in interest, leaving $125,805.

1990 -- Borrow $31,451 in order to invest $157,256. The return was -1.0%, generating a sub-total of $155,683. Pay back the loan plus $2,280 in interest, leaving $121,952.

1991 -- Borrow $30,488 in order to invest $152,440. The return was 60.0%, generating a sub-total of $243,904. Pay back the loan plus $2,210 in interest, leaving $211,205.

1992 -- Borrow $52,801 in order to invest $264,007. The return was 3.3%, generating a sub-total of $272,719. Pay back the loan plus $3,828 in interest, leaving $216,089.

1993 -- Borrow $54,022 in order to invest $270,112. The return was 15.1%, generating a sub-total of $310,899. Pay back the loan plus $3,917 in interest, leaving $252,960.

1994 -- Borrow $63,240 in order to invest $316,200. The return was 11.3%, generating a sub-total of $351,930. Pay back the loan plus $4,585 in interest, leaving $284,105.

1995 -- Borrow $71,026 in order to invest $355,132. The return was 45.5%, generating a sub-total of $516,716. Pay back the loan plus $5,149 in interest, leaving $440,541.

1996 -- Borrow $110,135 in order to invest $550,676. The return was 34.2%, generating a sub-total of $739,007. Pay back the loan plus $7,985 in interest, leaving $620,887.

1997 -- Borrow $155,222 in order to invest $776,109. The return was 55.6%, generating a sub-total of $1,207,625. Pay back the loan plus $11,254 in interest, leaving $1,041,150.

1988 -- Borrow $260,288 in order to invest $1,301,438. The return through June 3 has been 21.4%, generating a sub-total so far of $1,579,945. Account for the loan balance and a full year's interest at $18,871 and we have a current portfolio total of $1,300,787.

Without any margin whatsoever, the original $50,000 would have grown to $868,500 from January 1, 1986 through June 3, 1998. (This excludes taxes and trading costs.) That represents a 25.8% annualized return.

But with a modest level of margin each year, that annualized return climbs more than four percentage points a year to an annualized return of 30.0%.

This advantage is especially powerful for a stable and generally reliable approach as Keystone has been over the last twelve and a half years. There's been only one loss, a 1% slip in 1990. And there have only been two other years where the margin interest cost more than the gains made on the margined stocks (1988 and 1992). In general, because of the stability of the approach and the superior returns it has recorded since 1986, margin would have been a terrific addition to the portfolio.

Will it always be so sweet? Probably not. Whenever the annual return is lower than the margin interest rate, one would be better off without the leverage, but the long-term Foolish investor is likely to see returns better than the interest due to the broker. So a modest level of margin is reasonable in my mind.

If you're worried about getting a margin call, it would require an almost complete market melt-down under the conditions I've described here. With only 20% on margin, your entire portfolio would have to plunge more than 64% to trigger a margin call if your broker's equity requirement is 35%. Margin is a powerful tool if it's used sanely. If you get greedy on margin, you can get hammered as easily as you can with other risky ventures. Use common sense here. Fool on!

Check out the latest file updates for the Workshop:
New Rankings | 1998 Returns | New Database

[Robert Sheard is the author of the The Unemotional Investor (Simon & Schuster, 1998) available now at Amazon.com and your local bookseller.]