<THE FOOLISH FOUR>
by Robert Sheard
LEXINGTON, KY. (July 10, 1998) -- A frequent question concerning the Foolish Four approach is whether it's a good idea to juice or hedge the returns with options. If you've read the Fool for any length of time, though, you probably know that we eschew options entirely. Our belief is that it's enough of a task just to choose good stocks. Trying to predict the degree to which they'll move and the deadline by which they'll get there puts the odds firmly against the investor.
I have mentioned on occasion, however, another way of juicing the Foolish Four returns without having to hurdle the additional barriers of time and degree. A conservative level of margin leverage can increase the returns from such an approach as the Foolish Four, where the long-term performance is fairly consistent.
How does margin work? It's very simple, actually. When you purchase your stocks, you purchase more shares than you actually have cash to cover. (Be sure you have a margin account to do this; margin is not allowed in IRA accounts.) The difference between the cash you have in your account and what you actually spent is lent to you by your broker. There's no time frame on the loan; it is repaid automatically any time new cash comes into your account, whether from cash dividends, the sale of a stock, or additional cash you send in. The interest rate you pay on the loan is added to the margin balance each month, the rate varying from broker to broker. (The interest is a deductible expense on your taxes, by the way.)
Let's look at a sample using the Foolish Four returns from 1971 through 1996. Let's say you had invested $20,000 in 1971. For this model, I'll use a consistent level of margin leverage, borrowing an additional 25% of the actual value each year. (This means that each year you begin with 80% of the total investment coming from your own net worth and the remaining 20% coming via a loan from your broker. The maximum limit today is 50% on margin but a 20% margin level is a lot safer if the market swoons quickly.)
Right now I pay 7% on my margin balance, so I'll use that amount for this example. Obviously interest rates change and 7% is a pretty attractive rate, but for the sake of simplicity, I'll use it throughout the model. Feel free to run these numbers again with different margin rates. I'm also not accounting for taxes or trading costs. Trading costs, as you probably know, are a virtual non-event for the Foolish Four, and for simplicity's sake, let's assume you are paying the taxes out of another source of funds for now (more on taxes in a bit). On to the numbers!
Year one begins with a $20,000 investment and a loan of $5,000. The return in 1971 was 22.98%, bringing the account to $30,745 before repaying the loan and interest. The actual total at the end of the year is $25,395. And so on each year for the twenty six year test.
By the end of 1996, such a portfolio using an identical level of margin each year would have grown to a total of $8,664,835. That's an annualized rate of 26.30%. The traditional Foolish Four return over the same period was 22.91%. Even a moderate level of margin, then, makes a huge difference to the long-term growth (in this case a dollar difference of more than $4.39 million after twenty-six years).
If we go back and stick a 20% tax rate on each year's gain (working with the expected new capital gains tax rate), the portfolio still grows to just under $3 million, which is more than the pre-tax total for the Foolish Four without any margin.
In terms of consistency, the returns would have exceeded the 7% margin interest rate in nineteen of the twenty-six years, meaning that in only seven of the twenty-six years did margin borrowing hurt the portfolio's returns. As always, though, margin should be used with extreme caution so it doesn't turn into a gambling tool. A conservative level of margin used judiciously can be a powerful tool; abused it can do a portfolio in.
Current Dow Order | 1998 Dow Returns
[Robert Sheard is the author of the The Unemotional Investor (Simon & Schuster, 1998) available now at Amazon.com and your local bookseller.]
07/10/98 Close
Stock Change Last -------------------- UK + 1/8 53.63 IP - 1/16 43.31 MO + 7/8 40.06 EK - 13/16 73.56 |
Day Month Year
FOOL-4 +0.17% 1.46% 10.18%
DJIA +0.18% 1.72% 15.15%
S&P 500 +0.50% 2.69% 19.98%
NASDAQ +0.16% 2.55% 23.73%
Rec'd # Security In At Now Change
12/31/97 291 Union Carb 42.94 53.63 24.89%
12/31/97 206 Eastman Ko 60.56 73.56 21.47%
12/31/97 289 Int'l Pape 43.13 43.31 0.43%
12/31/97 276 Philip Mor 45.25 40.06 -11.46%
Rec'd # Security In At Value Change
12/31/97 291 Union Carb 12494.81 15604.88 $3110.06
12/31/97 206 Eastman Ko 12475.88 15153.88 $2678.00
12/31/97 289 Int'l Pape 12463.13 12517.31 $54.19
12/31/97 276 Philip Mor 12489.00 11057.25 -$1431.75
CASH $754.73
TOTAL $55088.04
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