My Favorite Margin
by Jim Stevens ([email protected])
Burlington, VT. (Oct. 1, 1998) -- Louis Corrigan has been examining the use of one kind of margin, the profit margin on a company's balance sheet. What's another kind? Ah yes, the feared margin loan from your friendly neighborhood stock broker. What's to be afraid of, you say? Plenty, but, as usual, where there is risk there is often reward. What's more, as we all know, Fools have oft been spotted where angels fear to tread.
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A margin loan is a loan you take out from your broker in order to buy more shares of stock then you actually could pay for in cash. It works like this: with $10,000 in a "margin" account, an investor buys 10 companies' shares for a combined price of $12,500 and a chuckling broker will be more than willing to lend the $2,500 that the investor does not have.
As long as the investor has set up and been approved for a margin account, the borrowing transaction takes place at the same time the orders are filled. No separate instructions or authorizations are needed at the time the loan is made. After the last order is filled the investor will have a cash balance of negative $2,500. To keep it simple I'm leaving out the commission charges. The "Long Stock Value" at that time will be $12,500 compared to the "Account Value" of $10,000. As you can calculate, our investor has 80% equity in the positions.
While the loan is outstanding, the broker charges the investor interest, of course, but does not require the investor to make any periodic payments against the loan principal. The interest rates on margin loans vary from broker to broker, they are lower than most consumer loan rates and may be tax deductible -- check with your tax advisor -- yada, yada, yada.
After the orders get filled, the extra risk and reward potential starts to show up. If the shares drop in value, the investor loses money 20% faster than without margin, or gains that much faster if the shares appreciate. Since the interest meter is always running, if the gains in the stock don't keep pace with the margin interest rate, it would have been better for the investor to have avoided margin altogether.
The real potential trouble with using margin starts if the positions really tank. Here's an explanation of what a typical broker will do as a margin account with a negative cash balance loses value:
Margin Calls: If your equity should fall to 30% or below, you will receive a letter requesting you to "provide funds or close out positions to bring your equity above 35% within three business days. If within three business days your equity is not above 30%, we will close out sufficient positions. If your account falls below 5%, or if market conditions warrant, we reserve the right to automatically liquidate all long positions and buy in all short positions."
Brokers will let you go out on margin down to 50% equity right off the bat. That means an approximate 29% drop in the value of an investor's shares would trigger a margin call. Since fluctuations in share prices of this magnitude aren't super uncommon, using this much margin may force investors to sell positions at the least favorable time. On the other hand, our investor starting off with a full 80% equity would have to see the account lose approximately 71% of its value before a margin call. Such a drop in a portfolio spread over 10 to 20 well chosen stocks is nearly unprecedented.
The potential rewards for using a conservative level of margin as I described are astounding. Robert Sheard outlines some calculations in his Leveraging Keystone report. It shows that employing the same margin leverage using the Keystone 10 Stock model from 1986 through June 1998 would have pepped up the CAGR by more than 4 percentage points, to 30.0% annually. This would have quickly turned an initial investment of $50,000.00 into a whopping $1,300,787 over the 11+ year period, compared to an already impressive $868,500/25.8% annualized without the leverage. Whoa!
Off camping with the kids for the weekend. Until Monday, Fools!
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