Sunday, February 1, 2009

Leveraging Dividends

Leverage Killed companies in 2008 and investors need no other indicator of the success that leverage played in the demise of so many companies than to look at their investment returns from the past year, those of the broader market and at companies continuing to have problems right now with heavily levered balance sheets.

There are clear lessons that can be learnt from how leverage poisons companies but borrowing money to invest under the right conditions can be a prudent investment decision for an individual investor.

I certainly don’t advocate that investors eager to invest in the current market go out and do so blindly with borrowed money but for the long-term investor an adequate amount of leverage can enhance returns if properly allocated and managed. Not only is the amount of leverage used important to consider but how that capital is allocated into investments to best position an investor for success.

An obvious strategy for using leverage when investing is to focus on dividends. Dividend paying stocks are often sought after with a leveraged investing strategy because of an investors’ ability to pay down interest and/or principal of borrowed funds with the cashflow provided from monthly or quarterly cash payments. The danger is that many inexperienced investors look at dividend paying stocks that yield 5% and with borrowing costs as low as 3-4% come to the immediate decision that borrowing to invest in such a company is a no-lose situation or risk-free.

I utilize leverage in my dividend investing activities because under the proper conditions and with a conservative approach I believe that borrowing to invest offers a disciplined investor an ability to accelerate returns over the long-term. What I don’t do is ever lose focus of the risk I expose myself to and consistently monitor the amount of risk I’m taking versus the perceived reward of my activities.

I want to provide four key concepts I use for any investor who might want to use leverage or is considering leverage for a dividend growth portfolio.


I – Conservative Amount

For an investor considering leverage I would first advise you to identify a sustainable amount of leverage for your investing strategy. There is speculation in the market that some hedge funds and investment banks were leveraged as much as 30:1 (or higher) entering into 2008 and this was clearly not sustainable under any market conditions. Borrowing $30 for every $1 committed to an investment strategy is sheer insanity and how this was sustained for any length of time goes beyond simple logic. To put this type of leverage into perspective: would you buy a $600,000 home with only a down payment of $20,000?

Fiscal mismanagement should not be tolerated and I certainly don’t advocate it for the individual investor. While only you know the amount of leverage you can handle I would politely advise that whatever your intended target (10%, 20% or higher) you first start with half. The threshold for my portfolio isn’t a percentage, but a dollar amount which I will touch on in section IV.

The important lesson is that whatever amount you intend to borrow, start with half and work from there. You might not find a happy medium right away but it’s always better to start from a conservative footing than finding yourself out too far on a cliff without anything stable beneath your feet. It’s only after you begin losing money when investing that you realize your risk tolerance is well beneath what you originally thought it would/should be.


II – Conservative Stocks

For an investment strategy where you intend to leverage your returns you want to be diversified against all types of risks. If you intend to create a leveraged portfolio of stocks for a medium to long-term portfolio try to include a balance of financials, consumer staple/discretionary, utilities, energy, real estate and industrial stocks in the portfolio.

I would initially target companies who aren’t leveraged heavily because this helps an investor avoid double leveraging your investments (your leverage plus theirs). Companies with solid business models, strong cashflows, fiscally conservative management teams and products/services in sustainable demand are key candidates for a leveraged investing strategy. If you have an opportunity to add stocks with distinct competitive advantages in their operations I would strongly consider those as primary investments.


III – Conservative Income

A collection of low yielding stocks likely won’t pay your bills and a collection of high yielding stocks may spell disaster for your portfolio in short order. Achieving a balance of income produced by the stocks in your portfolio goes a long way to making your strategy viable in all market environments. Stocks with high dividend yields above their historical average may be at risk for dividend cuts. For balance target a collection of low yielding companies who increase their dividends consistently at a high rate and medium-high yielding stocks who increase their dividends consistently at a conservative rate.

Conservative leverage in the beginning is key for the success of your strategy in the event of unexpected events. If you start with an amount of leverage beneath your targeted threshold and one or two of your dividend stocks cut their payout by 50% you haven’t over extended yourself on the basis of risk. It’s much easier to go up in leverage than down.


IV – Conservative Payment

Each investor should have a specific target for the amount of leverage they want to use in their portfolio. Some of my peers use anywhere from 30-45% as their basic benchmark for the amount of money they borrow to invest; for every $1.00 in their portfolio they use $0.30-0.40 of borrowed money to invest. My approach is slightly different since I take the ultra-conservative approach of using borrowed money when I invest and anticipate a worst case scenario.

The basic principle is this: Can my internal cashflow from the portfolio cover my costs?

When an individual or institution provides you with borrowed money they expect it back with certain terms and a timeline. Often a line of credit, loan or margin has a minimum requirement to repay over a set time period. This can be solely interest or interest and principal depending on the terms of your agreement and it is very important to understand these terms prior to investing borrowed funds. If you’re using a margin account this is a little different, but for this example I’ll simply use an investment line of credit (which I use).

My belief is that internal cashflow from my portfolio should cover my interest and 2-3% repayment of the outstanding principal in any given month. That’s my threshold for how much I will borrow in my leveraged strategy.

My reasoning is very straight forward: if I don’t have enough money coming in from my investments each month to pay the interest and repay a portion of the principal I owe I feel that I am taking on too much risk for my individual tolerance.

Example:

If my monthly cashflow is $200 in dividends and my interest rate is 4% I want to know how much leverage I can use to repay the interest plus 3% of my principal.

In really simple math if I were to borrow $6,000 I would pay approximately $20 in interest and my repayment on the principal (3%) would come to $180. On a $48,000 portfolio yielding 5% ($2,400 per year in dividends) this would put my leverage ratio at only 12.5%. I would be borrowing $0.12 for every $1.00 invested and able to manage the leverage adequately without committing any new money of my own on a monthly basis.

Obviously if you are adding savings to the portfolio on a regular basis you can afford to borrow more, but setting a target threshold for your monthly payment (interest + % of principal) helps you to stay conservative in your investing strategy and not overextend yourself with unnecessary risk.

Leveraging Dividends Review:

  • Understand how leverage can enhance/diminish returns
  • Understand the risk
  • Begin by using a conservative amount of leverage
  • Target a diversified group of stocks with higher margins of safety in their operations and financial health
  • Target safer sources of income
  • Set a payment plan that targets repaying both interest & a certain percentage of your outstanding balance from your monthly cashflow

This article was written by Triaging My Way To Financial Success. If you enjoyed this article, please vote for it by clicking the Buzz Up! button below.

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