Building An Asset Base Part 3 - On Debt 1 comments

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The traditional idea of corporate leverage is viewed with favour --- debt is seen as an additional source of capital that can be applied on top of equity to jack up return on equity. If we extrapolate this view of corporate finance to personal finance, surely it indicates that it is reasonable to borrow money to finance purchase of more investments?

But there is one critical difference. If the limited company becomes insolvent and cannot pay up its debt, the businessman can wind it up with limited impact on his personal assets (if he knew how to guard their ownership); for the individual investor, his personal assets are in the line of fire straightaway, and he could become bankrupt.

For shares investing in particular, what sources of debt capital are there? Many market players employ two avenues of debt financing: contra and margin. The former is essentially very short-term debt (with no interest) and the trader will have to dispose/pay back within 3-5 days since he is unable to pay up; the latter uses shares purchased as collateral and hence one could face margin top-up pressure from the broker should the collateral value drop (ie. share price drops).

To be sure, there is no right or wrong about using such debt financing, because the danger involved is basically a function of the trader's market experience and trading style. When done well, margin trading allows one to pyramid his gains as he buys more on the way up on the strength of his appreciated share collateral, a technique that Jesse Livermore perfected. The danger is part-emotional: such get-rich-quick hopes can seduce the trader to take more financial risk than he can handle; market experience is crucial here in managing such risk. Also, leveraged trades demand a keener awareness of short-term market conditions, and hence suit those with a shorter investment horizon. For those who are more inclined towards the long-term "weighing machine" mechanism of the stock market (ie. fundamentals sink in), like myself, margin debt or even worse, contra, is at odds with their investment style and hence should not be employed.

It always amazes me to read of how hedge funds can employ tremendous leverage to execute their quantitative-based arbitrage trades so that they can squeeze out the maximum gain from what by itself offers very thin profit margins; that's the nature of arbitrage. It is true that the risks associated with arbitrage are small but leverage magnifies these risks several fold. The collapse of Long-Term Capital Management was a classic example of over-exposure to leverage causing the ruination of a group of the world's most brilliant financial wizards.

There are other scenarios where the debt financing issue comes in. There was a recent discussion in an online forum on whether, in the purchase of a $1M property say, it was better to pay up the full $1M cash (assuming one had it) or to keep the cash and instead take up and service a $1M 4% interest home loan, given that the cash could (presumably) be employed to get better investment returns. Perhaps a good way to think about this is that one is effectively borrowing $1M from the bank at 4% interest rate, with the house as collateral, to invest for better returns.

Now, the danger is there, for who can guarantee >4% investment returns all the time? If the market turns down, most likely the stock market prices and the property market prices would be correlated, which means the aggressive borrower-investor sustains a double whammy. But I would argue that the loan structure is preferable to margin loans, for example, for the following reasons: (1)the property collateral allows lower interest rates ie. lower servicing costs, and more importantly, (2) the banks cannot apply pressure on the mortgagee even if the property value goes down (negative equity), so long as he services the loan faithfully. The main issue actually, is that it is not exactly prudent to take such a huge sum as $1M to play the stock market; it may be worth considering paying partially for the property and borrowing the balance from the bank, effectively creating a source of bank-financed property-backed loan to invest at higher returns. As I said, there is no black-and-white.

The long and short of it is that debt is an instrument to compound returns at a faster rate, and hence to build the asset base faster. However, the key thing to remember, as I pointed out earlier, is: don't assume that just because many successful businessmen have done it, hence it is the way to go. There are many more who have suffered the ill effects of it. And the sword being double-edged, it doesn't take long to wipe out the unlucky investor/trader, either.