Tuesday, July 31, 2012

Rule #12 Use Leverage for MORE positive cash-flow!

Under the right conditions, we are very comfortable using leverage to buy stocks.  Big amounts too.  A lot of people will warn against doing this.  I don't advocate that you necessarily do it, unless you understand the risks and are comfortable knowing what the possible outcomes are, and of course if the investment makes sense in the first place.  If the investment value craters, you are still obligated to pay your debt, so do your due diligence and make sure your really understand what you're getting into before borrowing to invest.    An example of a trade gone wrong would be Research in Motion.  If you borrowed to buy RIM a few years ago you would have lost your shirt on that trade by now as the stock is down 95% off its 2008 high, yet you would still be required to pay back everything you borrowed with literally nothing to show for it. Yes, it really can be that bad.  I would not have invested in RIM because they pay no dividend.

If you are starting to use leverage I would suggest you start in very small amounts until you become comfortable with it.   With all of that said I still don't consider it quite as risky as most will tell you it is, IF you pick stable conservative investments and NOT put all you eggs in one basket.  I have also observed that most people have been conditioned to believe that leverage on investments is risky, yet borrowing (leveraging) to buy a home is not.  I view leverage on a house to be just as risky as using leverage on stocks, perhaps even more risky.  This has to do with my view of a home being a liability.  It pays you nothing, and if it drops in value you are still on the hook to pay for it.  Buying something that is overpriced or built on shaky ground, whether its a house or a stock, can lead to a loss, and leverage can amplify those losses if you sell at the bottom.

I will tell you how I use leverage to increase our cash-flow and pay for itself, while minimizing the risk of the loan over time.  I do not try and hit home-runs with large capital gains, I try and hit base-hits.  Lots and lots of base hits, by creating a cash-flow positive situation while borrowing money to juice it up.  To be clear, what I am talking about is borrowing money, most likely from a bank, to purchase income producing assets.  I prefer Canadian stocks that pay dividends, but you can use a similar strategy to buy an income producing property such as a house or multi-family building, or any other investment with an income stream.  Usually its difficult to find investments with a high enough yield to use the strategy I use, but do your research and you may find some opportunities out there.   Note that I have no experience in rental properties, so I will give an example from a stock that I watch.

There are four basic criteria I use when using leverage.
  1. I typically leverage for 50-60% of the position... that is to say that I only borrow when I am willing to put up 40% of the money myself
  2. The dividend/distribution must be stable, preferably growing, and never have been cut.  
  3. The cost of borrowing must be relatively stable or be going down in the next 1-2 years.
  4. The leveraged investment portion must have a positive and growing cash-flow that covers the cost of borrowing today. If it doesn't make sense today to make the investment, I don't rush it.
So here's an example of a leveraged position I might take.  I will use an example for a corporation I follow call Leisureworld Senior Care (LW on the TSX).  They own Retirement Luxury condos and Full-Service Retirement Homes.  Full disclosure: They are on my watchlist, but I do not own any LW and I am NOT suggesting you buy any...  I am just using them as an example.  Lets go down my criteria

#1 I am willing to put up $4000 to purchase some LW stock, I will also borrow $6000 from the bank to make a total investment amount of $10000.  

#2 The retirement home industry is a stable one and will likely grow in the future as Boomers move into retirement lifestyle living centres, I would expect the dividend to be stable and likely grow at or near the rate of inflation.  At present, the dividend yield is 7% 

#3 At present, I dont see interest rates rising much, if at all, within the next 1-2 years due to the slow growth situation right now with the economy... rates are at all time low.  Now may be a good time to use leverage.  RBC currently has a Home Equitly Line of Credit that is set at prime +0.5.  With Prime at 3%, thats an interest only loan for 3.5%.  Thats pretty low.  You could also lock in a rate of some sort through other lending products at the banks, but I typically use a HELOC as you tend to get the best rates, although they are almost always variable and may fluctuate abruptly.

#4 I would get paid a dividend of 7% annually, and use that cash-flow to pay the loan interest of 3.5%, leaving a spread of 3.5% in positive cashflow. This means on the $6000 that I would borrow, I am making $210 annually.  Congratulations, the leveraged portion of this investment is is cash-flow positive!  The Dividend would have to be cut buy 50% or the loan interest rate double before it becomes neutral to cash-flow negative.  Sounds safe in the near term.  

Now that I've established this as a candidate, how might this look with respect to cash-flow?  In most cases I use the cashflow from the total position (both borrowed portion and my own portion's cashflow to pay down the loan).  As the cash-flow pays down the loan, no additional monies need to be injected into the position.  We treat the whole position as a closed system until it pays off the loan.  You can essentially start saving new monies for your next investment as this one pays itself off.  Here's a  spreadsheet showing what happens whey you use the money to pay down the loan assuming no change in dividend or interest rate.  

After 10 years, the loan is paid off and you have $10000 of LW stock.  This spreadsheet DOES NOT consider the likelihood that LW will increase the dividend, or that the annual interest rate will rise into the future.  Both considerations are quite likely... you can test different scenarios in your own spreadsheets.  This spread just shows that if left alone the dividends will pay off the loan in about 10 years and then you will have about $700 a year in free cash-flow from your initial personal contribution of about $4000.  Thats a 17% yield on the money you put up.  Not bad. Not bad at all.

This strategy works well on stocks that are in conservtive sectors with healthy stable cash-flow and if you don't go hog wild with leverage all at once.  I would never use this strategy on a company that doesn't have a healthy balance sheet, a sustainable dividend or if its in a volatile sector like high tech.. its just too risky.  With that said, I believe using leverage conservatively and under the right conditions can be very profitable.

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