<FOOLISH WORKSHOP>

Keystone Leverage Update      

by Jim Stevens ([email protected])

Burlington, VT (March 18, 1999) -- Workshop readers are constantly looking for ways to juice up the returns of investment models that have already proven to be historical market-beaters. A noble pursuit, to be sure -- I am constantly amazed at the new stock screens and different spins on existing Foolish Workshop models that continue to be researched and generously published in the Foolish Workshop Message Board.

As has been discussed before in previous Workshop columns, another way to spice up the return of just about any model is by using a conservative level of "margin" leverage. Using margin means you are borrowing money from your broker to buy more stocks than you would otherwise be able to afford with just the cash in your account.

Why would anyone do this? Basically, using margin will incrementally improve a stock portfolio's performance whenever the return on the stocks is greater then the interest rate of the margin loan. Since current margin interest rates are in the 6.5% to 8.5% range, an investor who believes he or she will be able to achieve long-term rates of 10%, 15%, or higher could benefit from using margin leverage.

I want to say very loudly to anyone new to using margin: Be Careful, Fools! While margin can magnify an uptrend in your portfolio, it has an analogous effect on any backslides. Be fully aware of this, because if short-term downward movements in your investments scare you, using margin will essentially scare you incrementally more then if you weren't using it.

I'm in agreement with Workshop originator Robert Sheard, who suggested limiting margin leverage to 20% of an overall portfolio. If you do that, it would take the historically unlikely event of a 60%-70% drop in portfolio value to trigger the dreaded "margin call." See My Favorite Margin for a more info on margin investing.

In a Workshop report Robert Sheard penned last June, the historical effect of using margin on a 10-stock Keystone portfolio starting in 1986 was shown. Below I've copied that exercise and brought it up to date. (A 7.5% margin interest rate is assumed.)

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% margin). The return was 23.8%, boosting the total investment 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 subtotal 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 subtotal 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 subtotal 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 subtotal 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 subtotal 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 subtotal 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 subtotal 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 subtotal 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 subtotal 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 subtotal 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 subtotal of $1,207,625. Pay back the loan plus $11,254 in interest, leaving $1,041,150.

1998 -- Borrow $260,288 in order to invest $1,301,438. The return was 68.84%, generating a subtotal of $2,197,377. Pay back the loan plus $19,522 in interest, leaving $1,917,567.

1999 -- Borrow $383,514 (holy credit rating, Batman!) in order to invest $2,301,081. The return through March 11 has been 11.89%, generating a subtotal so far of $2,574,678. Account for the loan balance and a full year's interest at $28,763 and we have a current portfolio total of $2,162,402. That's a lot of green beer!

Without any margin, $50,000 would have become to $1,344,057 from January 1, 1986 through March 10, 1999. (Taxes or trading commissions are excluded, so it's actually an exaggeration -- taxes would be owed.) That represents a 28.33% annualized return. With the 20% margin used in the example, the annualized return would have been improved to approximately 32.8%.

In summary, using a moderate level of margin can provide a turbo-boost to an already Foolish investment portfolio, for those Fools who are comfortable and aware of the additional risks involved.

Stay Foolish!