Author Topic: Safe(-ish) Margin Leverage - Tell Me I'm Wrong...  (Read 4004 times)

Voodooking

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Safe(-ish) Margin Leverage - Tell Me I'm Wrong...
« on: December 13, 2017, 03:46:52 PM »
So I used to run a non-leveraged, zero margin portfolio, for all the traditional reasons that are cited by respected value investors and generally wise people.

I then read 'Snowball', the Buffett biography, and the Buffett Partnership Letters, where I discovered that Charlie Munger grew his wealth by using lots of leverage (as I know how smart Charlie is, this was probably non-recourse debt, but still leverage). I also discovered that Warren Buffett used margin in his BPL accounts, but only up to a 'self-imposed limit' of 25% maximum of the portfolio value.

This made me think. If one is confident of superior returns, and has access to non-recourse lending, then leverage only "gets you where you are going faster", whether that's a profit or a loss situation.

I am well aware of the pitfalls of margin calls and the risk of having to liquidate position(s) at the worst possible time. However I began to wonder whether there was a "safer" way of using leverage...?

I run a series of small portfolios and have been experimenting with using margin leverage on some of them. For example, say the portfolio value is $10,000 ...I would request a margin of $10,000 on the account, yet employ Buffett's rule of limiting margin leverage use to only 25% of portfolio value ($2,500).

At the moment, I feel that this allows me to take advantage of a small amount of leverage, while protecting my downside by knowing that because I have several thousand dollars of 'free' margin available to provide a cushion / margin of safety if the market does drop or correct. This would obviously subsequently vastly reduce my available margin, but shouldn't force me to sell positions.

I'm looking to 'Stress Test' this idea and invite comments from other board members and look for them to suggest weak points in this strategy that I may not have considered.

Look forward to hearing from you.


Gregmal

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Re: Safe(-ish) Margin Leverage - Tell Me I'm Wrong...
« Reply #1 on: December 13, 2017, 04:45:24 PM »
Yes, I am almost always utilizing it. It really does come down to knowing when to bet big or otherwise simply constructing the portfolio to be lower risk. A diversified portfolio of preferred stock or investment grade bonds levered 3:1 likely won't kill anyone. Especially if actively and competently managed. Same thing for a low beta portfolio with holdings that have little correlation. I also like using leverage to put on merger arb plays. Essentially if each position is viewed as an independent opportunity to make money, It's a little different than just being a pig and wanting 2x the returns of such and such security.

Additionally, I have certain equity positions that I am comfortable with my understanding of in terms of volatility and risk. For instance, there are certain positions I will margin 100% as I am confident in their stability. IE GM in the low 30's I determined to be: cheap at 4-5x earnings, supported via a 5% dividend yield, have a margin of safety with 35% of mc in cash, and stable future cash flows given my views on the auto market. I viewed the "volatility risk" as downside being mid to high 20's. So a draw down from 32 to 25 wouldn't exactly kill me. This is just an example. I evaluate this kind of stuff on a case by case basis. I don't view it as risky as I'm comfortable with what I own and confident in my assessments. If I'm wrong I'm cool with that. The chances of the things I'm invested in "never coming back" are very remote. My leverage typically hovers around 1.3.

As a side note, if I remember correctly, in 2009, the year Tepper did 100%+, he was levered like 3-4:1. Sometimes you just go with your gut.

Rod

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Re: Safe(-ish) Margin Leverage - Tell Me I'm Wrong...
« Reply #2 on: December 13, 2017, 05:39:26 PM »
The problem I have with leverage is that you canít buy if the market crashes. Youíll just be trying to hang on. I went into the crashes in 2000 and 2008 with no leverage, but I leveraged up after the drop. I want always to have staying power and the capacity to borrow and invest at the bottom.

TwoCitiesCapital

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Re: Safe(-ish) Margin Leverage - Tell Me I'm Wrong...
« Reply #3 on: December 13, 2017, 05:43:33 PM »
The problem I have with leverage is that you canít buy if the market crashes. Youíll just be trying to hang on. I went into the crashes in 2000 and 2008 with no leverage, but I leveraged up after the drop. I want always to have staying power and the capacity to borrow and invest at the bottom.

This is how I envision the best use of leverage. I use call options to achieve upside leverage in a typical market cycle. It's more expensive, for good reason, but won't kill your cash position/flexibility in a downturn.

Margin seems mostly suitable for a market that has dropped 30-50% where you can be loading up at the bottom and slowly pay it off with dividend growth and capital gains over time.

Gregmal

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Re: Safe(-ish) Margin Leverage - Tell Me I'm Wrong...
« Reply #4 on: December 13, 2017, 06:00:47 PM »
The problem I have with leverage is that you canít buy if the market crashes. Youíll just be trying to hang on. I went into the crashes in 2000 and 2008 with no leverage, but I leveraged up after the drop. I want always to have staying power and the capacity to borrow and invest at the bottom.

I'd imagine it also then has something to do with one's ability to access leverage. One could very easily be modestly levered and still have liquidity in the event of a drawdown. If you are using leverage the single most important aspect is managing it. 

Cigarbutt

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Re: Safe(-ish) Margin Leverage - Tell Me I'm Wrong...
« Reply #5 on: December 13, 2017, 06:28:48 PM »
Two questions that you may want to ask yourself:
Is it necessary?
Is it appropriate?
Many variables to look at including other personal sources/uses of cash flows.
Confidence in what you hold and the associated margin of safety also count.
Another variable to consider is to asses if what you hold is already levered.


Perhaps, in selected instances, starting with low or no leverage may give you courage in averaging down.
Margin interest is deductible but know the rules (specific to your tax jurisdiction).
Personal decision.

frommi

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Re: Safe(-ish) Margin Leverage - Tell Me I'm Wrong...
« Reply #6 on: December 13, 2017, 09:05:01 PM »
The timing for net leverage > 100% is probably not optimal, but i can imagine using it after a bigger market drop. But i wouldn`t go with margin debt, i would just sell puts. That way you won`t have the full upside, but you are paid to wait instead of paying interest on your margin.
At the moment i do this and buy puts on overvalued/problem stocks to offset market exposure, so that the option premium in my whole portfolio is near zero and my net market exposure is only 30%. I think this is the cheapest and safest form to implement a long/short portfolio.

Devils_Shadow

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Re: Safe(-ish) Margin Leverage - Tell Me I'm Wrong...
« Reply #7 on: December 14, 2017, 01:39:16 AM »
I don't think anybody who has gotten really wealthy from investing in asset classes has gotten there without some form of leverage.

HFs/PEs - OPM - leverage from LPs at negative cost.

Buffett - insurance float - zero or negative cost of float. It has been estimated that his float has meant a leverage of 1.6x for him over his investing career.

John Malone - was always levered 4-5x in his cable vehicle. that biz was suitable for such leverage (not every biz is though).

Sam Zell and other real estate luminaries - always levered. RE usually is.

Who doesn't use leverage? The issue is in what form are they using it. It's all a quasi carry trade. WB is running a carry trade on his float. HFs/PEs are running a carry trade relative to their cost of OPM.

There is no sustained non linearity in wealth creation without some form of leverage.

writser

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Re: Safe(-ish) Margin Leverage - Tell Me I'm Wrong...
« Reply #8 on: December 14, 2017, 02:56:20 AM »
I don't think anybody who has gotten really wealthy from investing in asset classes has gotten there without some form of leverage.

On the flip side: most people who went broke from investing probably used leverage.
When you are dead, you do not know you are dead. It's only painful and difficult for others. The same applies when you are stupid.

s8019

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Re: Safe(-ish) Margin Leverage - Tell Me I'm Wrong...
« Reply #9 on: December 14, 2017, 07:58:55 AM »
To understand "base rate" of great people investing with leverage let's add a few more cases: Benjamin Graham used leverage. And he almost went broke. I believe it was money from Newman father or something like that which saved him. Keynes also used leverage and he also almost went broke... twice. First time saved by his father and second time by his friends. After that if I remember correctly he imposed a 10% limit on margin to total portfolio value.

By the way equity is a junior claim on a company cash flow and you are usually taking on operating and financial leverage when investing in equity. So, in financial terms a share is an option on the company cash flow. Levering up an option sounds like a little bit crazy idea for me. However it is just me, it does not mean that shrewd people cannot use leverage to their advantage.