Smart Use of Margin Enhances Returns

By on May 9, 2006

Originally published on:

September 6, 1996

A week ago the market had some unsettling activity after a revised GDP growth report showed the economy to be stronger than originally reported. Of course, this news caused the bond market to drop and rates are now 1/4 percent higher than they were a few weeks ago. Stocks also tanked on the news. This week we got a new jobs report that indicated that the economy may be strong, but not as strong as earlier estimates. This caused the opposite effect on the markets and they rallied today. These economic numbers reflect what happened in the past and have no predictive value of where the economy is headed now. The economy surged last quarter because long term rates were low at the beginning of the year. Rates have risen over the last 6 months and the economy is now slowing, not accelerating. The bond market will do it’s magic and really slow this economy down if we continue to get reports that even hint that the economy is accelerating. Will this slowdown cause profits to fall substantially? I don’t think so, but it doesn’t really matter what I think because the Tactical Timing System takes care of the trading decisions. It leaves my sometimes faulty thought processes out of the equation (except for stock picks) and will likely lead me to better than average returns.

Smart Use of Margin Enhances Returns

When most investors hear the word margin, thoughts of wild speculation, terrible market crashes and people jumping out of windows fill their heads. Even the long time market patriarch Sir John Templeton has said that investors should never buy stocks on margin. This issue will focus on the use of margin in stock accounts. Margin has been around for a long time and is a tool that investors can use to enhance their returns. Only if investors understand the risks can they really make a judgment whether or not margin is for them.

For the uninitiated, buying securities on margin is the use of leverage to magnify returns when the market is rising. If not used with care, margin will also accentuate losses when the market is falling. Buying stock on margin is simply using stock in your account as collateral to borrow money from your broker and buy more stock. The SEC rules allow an investor to buy $2,000 worth of stock for $1,000. When margin is used to its extreme on an indexed portfolio, it will nearly double a 100% invested portfolio’s rate of return on the upside and more than double the rate of loss on the downside. The reason for this inequity is that interest is paid to the broker for the borrowed funds so you had better have good reason to believe that the holdings in the portfolio are going to go up if you utilize margin to the maximum extent. If the stocks in the account drop and the equity falls below the minimum maintenance level the investor is required to come up with more cash or stock. If the investor can’t fortify the equity in the account, then stocks will be sold to bring the equity to the minimum maintenance level. This is what is called the dreaded “margin call”.

Most investors are fearful of using margin in their accounts, as well they should be. Margin buying tends to increase dramatically near market tops, just when investors should be cutting back on the use of leverage. Unless an investor has a good, well thought out strategy, buying on margin can devastate a portfolio when the market falls. Investors are not unlike a company’s unseasoned management who expands capacity when prices for whatever they produce have peaked. Take for example most DRAM manufacturers who have expanded capacity only after prices were peaking, and are now paying dearly as prices for their chips are plunging below their cost of manufacturing them. Just think how much better off these companies would have been had management expanded capacity before prices rose and were ready to cut back on production as soon as prices began to weaken. The principal is exactly the same when investing in stocks. The time for margin buying is when stocks are unpopular. This is exactly the opposite time most investors get the nerve to borrow money from their broker to buy more stock. It is just the natural order of the market and human nature that people are most committed to stocks at the peak in prices. The best way to deviate from crowd psychology is to utilize a strategy that does not allow emotion to come into play.

It is impossible to know when prices are peaking or bottoming until well after the fact so there is no strategy that will get you in and out at the exact top or bottom. Even getting in and out within 10% of the top or bottom is something that some will claim they can do, but if you follow their recommendations you’ll find out that they can’t consistently perform this feat.

The Tactical Timing System was designed to move a portfolio to a more aggressive stance in steps as the market becomes more undervalued. As the market becomes overvalued the inverse occurs as commitments to stocks are decreased. The aggressive portfolio will utilize margin when the opportunity arises to purchase stocks at attractive valuations. The use of margin has been called a two-edged sword. The Tactical Timing System was designed to take advantage of one of the edges; the one that results in above average returns. However, there is no guarantee that we won’t get nicked by the other edge. Prices that are undervalued can become cheaper and cheaper sapping the will of the most determined investor. Adherence to the system is necessary to avoid falling victim to the crowd psychology of fear. I know there will come a time again when investors wish they had never heard of the stock market and are selling in droves. Following the Tactical Timing System will allow me to pick up stocks at low prices and be prepared for the eventual upturn.

Portfolio Activity

The conservative portfolio had some turnover the past two weeks.
The Stock Market Advantage basic rules required that a portion of Sports and Recreation (WON) be sold due to it becoming more than 10% of the conservative portfolio. 50% of the position was sold. No other security was purchased in it’s place due to the balance between cash and securities being within 5% of the recommended allocation after the sale of WON.
Raymond James Financial (RJF) also became more than 10% of the conservative portfolio. 40% of RJF stock was sold and Mylan Labs (MYL) was chosen as an investment for the proceeds.

Stock Updates

Mylan Laboratories (held in the conservative portfolio)

Mylan Labs is the largest manufacturer of generic drugs in the U.S. and does some of their own research and development of drugs. MYL will be a beneficiary of the aging of the baby boomers. Volumes of drugs shipped will rise substantially in the years ahead. Recently, there has been severe price competition in the generic drug industry. This coupled with a dearth of new drug approvals for Mylan with fewer drugs coming off-patent has caused weakness in MYL stock. These problems are temporary in nature and should cause no long lasting damage to the company. MYL is trading for the same price it did in 1992. The company is very strong financially, with a high current ratio and a very favorable long term debt to equity relationship. Once the company gets back on a growth track the stock should double within a short time and keep going from there. This can be expected within the next couple of years. It is impossible to pick a bottom for MYL, however, it has major support in the mid-teens.

Unilever NV (held in the aggressive portfolio)

Unilever (UN), the giant Dutch consumer products company, received a shot in the arm and broke out of a trading range this past week when Niall FitzGerald, the new co-chairman, said that management would be aggressively de-diversifying the company by selling off underperforming businesses. According to the Wall Street Journal, Unilever is well represented in the emerging markets. It operates in more than 90 countries and sells products in a total of 160 countries. The company logs 30% of it’s sales in developing countries and Mr. FitzGerald predicts this will rise to 50% in a decade.

Unilever looks like a potential Coca Cola type company. I know the PE will never get as high as Coke, but if management can get it’s act together we could see the killer combination of expanding earnings growth and a growing PE to shoot the stock up further.

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>